Mortgages vs. home equity loans are two options for financing the purchase of a house. A first mortgage is an initial loan you take out to buy a property. To cover part of the cost of your property, you might opt for a second mortgage or a home equity loan. Before deciding which loan is appropriate for you, it is essential to comprehend the various distinctions between a mortgage and a home equity loan.
Homeowners used to be able to deduct interest paid on both types of loans, but this is no longer the case with the new 2018 tax law. However, interest on up to $100,000 of debt that builds or improves your home can still be deducted. Additionally, first mortgages and refinance loans are tax deductible up to a limit of $750,000.
Mortgages and home equity loans require borrowers to pledge their homes as collateral or risk the lender seizing the property. Although these loan types have this significant similarity, there are also crucial differences between them.
Mortgages
A mortgage is when a financial institution, such as a bank or credit union, gives money to a borrower so they can buy a house. In general, the lending institution will give up to 80% of the appraised value or the home’s purchase price — whichever is less. Continuing with our $200,000 example from above, if the appraisal value is at that amount, then the potential buyer would be given $160,000 and have to come up with the remaining 20%, which in this case would be $40,000, as their down payment.
The United States Department of Veterans Affairs (VA) and U.S. Department of Agriculture (USDA) loans are examples of non-traditional mortgages requiring no down payment. The Federal Housing Administration (FHA) mortgages allow customers to put as little as 3.5% down if they pay mortgage insurance.
The interest rate for a mortgage can either be fixed (meaning it will stay the same throughout the loan) or variable (which means it changes yearly). The borrower repays the borrowed amount and any additional interest accrued over time.
If a borrower falls behind on their mortgage payments, the lender can take possession of the home through foreclosure. The lender will then sell the house, usually at auction, to regain their money. If this happens, the first mortgage takes priority over any other loans that have been made against the property, like a second mortgage or HELOC. The original lender must be paid off before other lenders receive the foreclosure sale payment.
Read More: What Type of Mortgage Program Is Best for You?
How a Mortgage Works
To qualify for a mortgage, you typically need to meet specific requirements set by the lender, which may involve:
- A minimum credit score that shows a history of responsible payments.
- A debt-to-income (DTI) ratio that shows you earn enough money to cover other expenses such as a car loan or credit card.
- A minimum down payment.
- Enough cash to cover closing costs on the mortgage.
The most frequent form of mortgage is a 30-year fixed-rate loan, although there are other choices for borrowing money for a house, such as 15-year fixed-rate loans and adjustable-rate mortgages.
Home Equity Loans
A home equity loan is also a type of mortgage. The primary difference between a home equity loan and a regular mortgage is that you take out a home equity loan after buying and accumulating equity in the property. A buyer may use a mortgage to purchase the property for the first time instead of using other lending tools such as capital gain loans or an FHA loan.
As the name implies, a home equity loan is secured by a homeowner’s equity in the property, which is the difference between the property’s value and the current mortgage balance. For example, if you owe $150,000 on a house worth $250,000 and have $100,000 in equity, you can take out an additional loan with that money as collateral.
Like a regular mortgage, a home equity loan is an instalment loan repaid over a set period. The percentage of equity lenders are prepared to provide varies, and the borrower’s creditworthiness helps influence this decision.
How a Home Equity Loan Works
A home equity loan is available after you’ve paid off the majority of your house or if you’ve already paid it off in full. If you’re still paying your mortgage, a home equity loan is a second mortgage that allows you to borrow extra money based on the value of your property.
Imagine that your home’s value is $300,000, and you still owe $125,000 on your first mortgage. You have a total of $175,000 in equity to use as collateral for a loan. Depending on other financial factors like credit score and lender guidelines, you may be able to borrow up to 80% or 85% of that value. The variables can differ depending on various conditions, such as if the home is the primary residence or an investment property and if the borrower is alone or has a co-borrower.
Read More: How To Maximize Your Home Equity? Best Ways To Tap Into Your Home Equity.
What’s the Difference Between a Home Equity Loan and a Home Equity Line of Credit (HELOC)?
The repayment schedule is the primary distinction between a home equity loan and a HELOC. A home equity loan is a fixed, one-time lump sum that is repaid over time, in a nutshell. A HELOC is similar to a credit card in that it’s a revolving line of credit secured by a house that you can use and pay back over time.
Mortgage vs. Home Equity Loan
Both a mortgage and a home equity loan require you to borrow money with the understanding that you will repay it. If you don’t adhere to this agreement, the lender can take your home as collateral for both types of loans. Because these loans usually come with a large sum of cash, the application process is understandably intense.
There are stages in which the home equity loan process is faster, but generally speaking, the steps for each type of loan (evaluating income, employment history, etc.) are similar.
The lender can waive the requirement for an in-person appraisal and replace it with different valuation methods that are faster and less expensive if the property is worth less than a specific value — usually under $500,000. In addition to saving time, home equity loans typically have lower closing costs. One exception: If you close your home equity loan early, many lenders will charge an early closure fee, generally equal to three years’ interest.
While mortgage closing expenses are typically lower than home equity loans, rates on home equity loans are usually higher than mortgage rates. That’s because, in most cases, the lender of the original loan is first in line to get repaid if your property goes into default.
So Can I Use the Money for Anything?
Technically, yes, you could spend the cash on anything. However, keep in mind that you’re borrowing against your house — the place where you live and raise a family. So, paying for a vacation or that boat you’ve been eyeing with the proceeds from your home equity loan may not be the most incredible idea.
Home equity is beneficial in many ways and it can finance things that will improve your life. Some people use home equity loans or lines of credit to do renovations, which raises the property’s value. Others install pools or buy new furniture with the money. You can use the proceeds for anything you like, but reviewing your options is best before committing to a long-term financial contract.
How Do Mortgages and Home Equity Loans Affect Your Credit?
Clean repayment history is one of the top things lenders like to see. It’s a great way to show financial responsibility, which can be attractive whether you’re taking out a loan or looking for other opportunities. While repaying mortgages and home equity loans on time will boost your credit score, there may be an initial dip in your score. If this happens, take a deep breath and relax knowing that your score will eventually recover and improve with punctual repayment.
Which Has Lower Interest Rates? A Mortgage or a Home Equity Loan
A mortgage typically has a lower interest rate than a home equity loan. If you can’t make your payments and default on the loan, the lender will be the first in line to get paid back for selling your house. In other words, lenders see it as less of a risk.
If your current mortgage has a low-interest rate, you may choose to borrow extra cash by taking out a home equity loan. However, remember that the funds can’t be deducted fully for tax purposes because they are used to improve your house.
Consider a comprehensive mortgage refinance if the interest rates on your existing loan have gone down significantly since you took out the original mortgage — or if you need the cash for reasons other than to pay off your house. If you refinance, you might obtain a lower rate on the rest of what you owe, as conventional fixed-rate loans are cheaper than home equity loans.
Special Considerations
Loan-to-Value (LTV) Ratio
Lenders look to the loan-to-value (LTV) ratio to determine how much money an investor can borrow. You calculate the LTV ratio by adding the loan amount to the amount still owed on the property, dividing that number by the appraised value of the property, and then totalling it up. If a borrower has made significant progress paying down their mortgage or if the value of their house has gone up dramatically, they may be eligible for a large loan.
Second Mortgages
In many situations, we consider a home equity loan as a second mortgage, such as when the borrower already has a mortgage on their house. If the property goes into foreclosure, the holder of the home equity loan does not get paid until after the first mortgage lender is reimbursed. As a result, home equity loans have higher interest rates than traditional mortgages, and their risk of default is more significant.
Second mortgages, on the other hand, are not all home equity loans. A borrower who owns their house free and clear might choose to borrow against the property’s value. In this instance, the lender is the first lienholder. These loans may have higher interest rates but require less paperwork. For example, there may be no requirement beyond an appraisal to complete the transaction.
Tax Deductibility of Mortgages and Home Equity Loans
The Tax Cuts and Jobs Act of 2017 have made home equity loans and mortgages more similar in one aspect: their tax deductibility.
According to the act, interest on a mortgage is tax deductible for mortgages of up to either $1 million (if you took out the loan before Dec. 15, 2017) or $750,000 (if you took it out after that date). This new limit applies to home equity loans as well, and the total threshold for deductions on all residential debt is $750,000.
There is, however, one catch. Before, homeowners would deduct interest on a home equity loan or HELOC no matter what they spent the money on — whether for home improvements or to pay off high-interest debt such as student loans or credit card balances. The act suspended this deduction for interest paid on home equity loans from 2018 through 2025 unless the loan is used to buy, build, or substantially improve the taxpayer’s primary residence.
Bottom Line
When you take out a home equity loan or mortgage, your home is collateral. Be sure to do your research, create a budget, and develop a financial plan before taking out a mortgage or home equity loan. This way, you can figure out whether owning is in your best interest (as opposed to renting) and plan accordingly. With the correct information, both mortgages and home equity loans can help you reach your goals.
Do you have any questions about mortgages and home equity loans? Leave a comment below or Contact us for a free consultation.