Home equity loans are debt products that cater to current and prospective homeowners. Mortgages, on the other hand, lets you buy a new home or refinance an existing one. But maybe you aren’t entirely clear about the key differences between the two options.
In this guide, you’ll learn how home equity loans and mortgages work and how to use each option. You’ll also discover key differences and similarities between the two and how to determine the best fit for your financial situation.
Home Equity Loan vs. Mortgage: What Is The Difference?
There are distinct differences between home equity loans and mortgages.
What Is a Mortgage?
A mortgage is a loan product you can use to buy a new home. You can also use it to refinance your existing home to get a lower interest rate and more affordable monthly payment.
Suppose you have a sizable amount of equity in your home. In that case, you may qualify for a cash-out refinance, which is a mortgage product that lets you convert a portion of your equity into cash.
What Is a Home Equity Loan?
A home equity loan acts as a second mortgage. It lets you borrow against the equity in your home or the difference between your home value and mortgage loan balance and is also available to borrowers with a decent sum of equity built up.
How Does a Mortgage Work?
As mentioned earlier, you can use a cash-out refinance to pull equity from your home. Most mortgage lenders let you borrow up to 80 percent of your equity, and you’ll receive cash at closing.
Here’s an example of how it works:
- Assume your home’s value is $425,000, and you owe $255,000 on your mortgage.
- If the lender approves you for a cash-out refinance, you could pull out up to $85,00 in cash. The lender will also pay off your first mortgage at closing.
- You’ll get a new loan for $340,000 ($255,000 + $85,000).
When it’s time to resume payments, you’ll make your mortgage payments with the new lender for the life of the loan.
How Does a Home Equity Loan Work?
A home equity loan acts as a second mortgage and lets you convert your equity to cash. But you won’t have to refinance your existing mortgage. Instead, you’ll get a lump sum, typically capped at 85 percent of your home’s equity, that’s repayable in equal monthly installments over a 20- to 30-year period.
To illustrate, if your outstanding mortgage balance is $265,000 and your home is worth $475,000, you could get a home equity loan of up to $138,750 ($475,000 * .85 – $265,000).
The Similarities Between a Home Equity Loan and Mortgage
Before learning about the differences between the two loan products, here’s a closer look at the key similarities.
Use of Property as Collateral
Both home equity loans and mortgages use your home as collateral. This means your home is the guarantee for the loan, and if you fail to make the required payments, the lender may take possession of (or foreclose) your property.
Since your home acts as security for these loans, they generally come with lower interest rates compared to unsecured lending like personal loans or credit cards.
Potential Tax Benefits
Another similarity between home equity loans and mortgages is that you may benefit from potential tax deductions. In some cases, the interest paid on both types of loans can be tax-deductible, depending on how the funds are used and your eligibility for deductions.
For mortgages, the tax deductions apply to interest paid on the first $750,000 of the loan, while for home equity loans, the deductions may only apply if the funds are used for home improvement purposes. Always consult with a tax professional to determine your eligibility to take advantage of these deductions.
Risk of Foreclosure
As with any type of secured loan, both home equity loans and mortgages carry the risk of foreclosure. If you fail to meet your payment obligations or default on the loan, the lender has the right to foreclose on your property to recover their funds.
To mitigate this risk, make sure to weigh your borrowing options carefully and only take on loans for amounts you can comfortably manage.
Key Differences Between a Home Equity Loan and Mortgage
Now that you understand the features home equity loans and mortgages share, here are some key differences between the two.
Loan Purpose
When considering a home equity loan versus a mortgage, it’s vital to understand the loan’s purpose. A mortgage is used to purchase a property. At the same time, a home equity loan allows you to tap into your property’s equity for various expenses, such as home improvements, college tuition, or education costs, or to consolidate high-interest debt.
Interest Rates
The interest rates on home equity loans and mortgages also differ. Mortgages generally have lower rates because they are secured by your property. By contrast, home equity loans tend to have higher interest rates as they’re based on the equity in your home. Depending on the lender, you may be offered a fixed rate or variable rate.
Loan Terms
Mortgages and home equity loans come with varying loan terms. Mortgage terms are typically long-term, ranging from 15- to 30 years. However, home equity loans have shorter terms, averaging 5- to 15 years.
Repayment Procedure
Repayment procedures for home equity loans also vary. With a mortgage, you’ll typically follow an amortization schedule, which means your monthly payments include both principal and interest. The payments gradually decrease the loan balance, and you’ll eventually pay the loan in full.
However, you get a lump sum of money with a home equity loan. You’ll start repaying the loan with fixed monthly payments that also include principal and interest. As mentioned above, the repayment period for a home equity loan usually ranges from 5 to 15 years.
Qualifying for One
Different criteria also apply when qualifying for mortgages and home equity loans. For a mortgage, lenders assess your credit score, income, employment history and debt-to-income ratio. Having a good credit score and a steady source of income can increase your chances of getting approved.
For a home equity loan, you must have a sufficient amount of equity in your property. Lenders will also consider your credit score, income and current debt load.
Deciding Between a Home Equity Loan and Mortgage
Factors to Consider in Choosing Between the Two
When deciding between a home equity loan and a mortgage, consider the following factors:
- Purpose: A mortgage is used to purchase or refinance a home, while a home equity loan is used for other expenses after you own the property.
- Interest rates: Mortgages typically offer lower interest rates compared to home equity loans.
- Loan terms: Mortgages have longer repayment terms, while home equity loans are shorter-term loans.
- Equity requirements: Home equity loans require you to have built up a certain amount of equity in your home before borrowing.
- Tax deductions: Interest paid on mortgages is tax-deductible, while interest paid on home equity loans is only deductible if used for home improvements.
When To Use a Mortgage vs. a Home Equity Loan
It’s more sensible to use a cash-out refinance mortgage if:
- You qualify for a lower interest rate.
- You still have several years remaining in your loan term.
- You’d prefer to make a single monthly payment instead of two.
- You can afford a higher monthly mortgage payment.
When To Use a Home Equity Loan vs. a Mortgage
However, a home equity loan is likely the better choice if:
- You already have a competitive interest rate.
- You’re nearing the end of your loan term.
- You’d prefer to keep your monthly mortgage payment low.
- You want to keep closing costs to a minimum.
Other Ways to Access Home Equity
Beyond home equity loans, there’s another way to tap into your equity.
Cash-Out Refinance
When homeowners are in need of extra funds, they often consider options such as a home equity loan or cash-out refinance. Both of these options involve borrowing against the value of their homes.
A cash-out refinance is a type of mortgage refinancing that allows homeowners to access the equity they have built up in their homes. Essentially, it involves replacing your existing mortgage with a new one, with the new loan amount being higher than the outstanding balance on the original mortgage. The difference between the two is then paid out to the homeowner in cash.
Home Equity Loan vs. Mortgage: The Bottom Line
Ultimately, deciding between a home equity loan and a mortgage comes down to your financial situation and which works best for you. Conduct a cost-benefit before moving forward to ensure you make a good choice.
Frequently Asked Questions (FAQs)
When deciding between a home equity loan and a mortgage, it’s essential to compare the costs involved with each option. In general, mortgage rates tend to be lower than home equity loan rates.
However, home equity loans may have lower closing costs since they don’t require traditional mortgage fees like the appraisal fee and title insurance. Furthermore, the amount you can borrow with a mortgage can be much higher than with a home equity loan, making it more suitable for purchasing a home or making significant home improvements.
Although home equity loans offer several benefits, like lower interest rates, some potential downsides should be considered. For starters, your home is used as collateral, which means you could lose it to foreclosure if you fail to make the payments. Plus, home equity loans add to your overall debt, which can be a concern if you already have substantial financial obligations.
Other potential risks include borrowing more than you need, which can lead to difficulty repaying the loan or burdening yourself with unnecessary debt. You could also be stuck with higher rates that may be higher than mortgage rates, making it a more expensive borrowing option overall.
If you already have a mortgage and need additional funds for home improvements, debt consolidation or other expenses, a home equity loan might be a better option. It often has lower interest rates and provides a tax deduction on the loan’s interest if used for eligible purposes.
However, a mortgage is the most appropriate choice if you’re looking to purchase a new home. A mortgage allows you to borrow large sums with potentially lower interest rates, and it’s specifically designed for home purchases.
No, a home equity loan does not replace a mortgage. A mortgage is a loan used to purchase a home or refinance your existing home loan. A home equity loan is a separate loan that you can obtain while you already have a mortgage or after you’ve paid your mortgage off.
It taps into the equity built up in your home and provides additional funds for various purposes but does not replace or change the conditions of your primary mortgage.
