The Difference Between a Home Equity Loan and a Mortgage
May 14, 2021 |
8 Minute read
Home Equity Line of Credit vs. Mortgage vs. Home Equity Loan: What’s The Difference?
When you’re researching home financing options, you’ll undoubtedly encounter a slew of terms that can leave your head spinning. Home equity loan vs. mortgage? Mortgage vs. HELOC? What does it all mean? And what’s a HELOC, anyway?
All of these terms refer to ways homeowners can finance (or refinance) their next home purchase. These financing methods all work similarly, but they have a few subtle — yet key — differences you need to know.
This article will discuss the differences between a mortgage vs. home equity loan vs. home equity line of credit (HELOC) to help you navigate this tricky terrain. More importantly, we’ll help you figure out which option is the best for your situation.
Home Equity Loan vs. Mortgage
If you’ve found yourself asking, “Is a home equity loan the same as a mortgage?” you’re not alone. This common question stumps many new homebuyers.
The answer: not quite. There are a few aspects between a home equity loan vs. a mortgage that set them apart. But before diving into their differences, let’s start by talking about their similarities.
Home Equity Loan and Mortgage Similarities
First, both a mortgage and a home equity loan are classified as secured loans. You’re taking on debt to buy a property and, in exchange, offer your house as collateral to the lender. If you default, the lender can then sell or foreclose your property to recoup his or her losses from your non-payment. Now, let’s take a closer look at the details of both secured loan options.
What is a Mortgage?
A mortgage is any loan specifically used to buy a home. Banks and private lenders commonly offer them, but you can also find mortgages backed by the government, such as FHA (Federal Housing Administration) and VA (or Veteran Home Affairs) loans. You can usually borrow up to 80% of a home’s appraised value or purchase price. First time home buyers can borrow up to 95% of a home’s value or purchase price instead.
Mortgages often require that you already have a house you want to finance and be liquid enough to afford the remaining 20% down payment as part of your mortgage approval process. However, some mortgages (like the FHA and select lenders) can agree to less than 20%.
Most mortgages have a fixed interest rate throughout the loan term, although a few have variable interest terms. The typical length of a mortgage is 15 to 30 years. There are however 10, 20, 25 years fixed rate mortgages as well.
How is a Home Equity Loan Different?
A home equity loan is, by definition, also a mortgage. It can have either a fixed or variable interest rate, and you generally pay it on an installment basis.
But the key difference between a home equity loan and a mortgage is when you use it. You take out a home equity loan on a property you already own, while with a traditional mortgage, you use it to buy a property.
Home equity loans enable you to borrow money against the equity you have built up on your property. Your existing equity is a measurement of how much of your house you actually own. You calculate this by subtracting the mortgage you still owe from the fair market value of your home.
How Does a Home Equity Loan Work?
Let’s say your house is worth $300,000, and you still have a mortgage balance of $120,000. Your home equity, in this case, is $180,000. As a result, you could take out a loan with $180,000 (your home equity) as collateral.
Why would you want to get a home equity loan? For one, they’re easier to qualify for because you have your equity as collateral. Interest rates are also typically lower than most consumer loans. Because of this, people often use home equity loans to pay for significant one-time expenses like home renovations or a college education. They’re also a fantastic way to consolidate debt.
The same rules of a mortgage still apply with home equity loans, however. If you default, the lender can seize and foreclose your home to pay for the losses. However, home equity loans come with one considerable risk — the market value of your house could decrease. If that happens, your loan amount could be larger than your home’s value, potentially losing you money on a sale.
Refinancing vs. Home Equity Loan
Let’s expand our discussion on mortgage vs. home equity loan by throwing another option into the mix: refinancing.
Refinancing is similar to a home equity loan. In both cases, you’re banking on the equity you’ve built on your home as collateral. However, your reason for getting each loan is different.
A home equity loan essentially turns your house into an emergency source of cash. If you need money for big purchases, such as your child’s college education or remodeling your house, this is typically the route you’d take.
With refinancing, your goal is to trade your old mortgage for a new one with a lower interest rate. Say you took out a mortgage on your loan 15 years ago at an interest rate of 4.8%. Swapping for a new mortgage with a lending rate of 3.2% means you’ve lowered your interest by 1.6%, potentially saving you hundreds of dollars in monthly payments.
Most refinancing options come as one of two types:
A cash-out loan refinance works like a home equity loan in that you’ll receive enough money to finance other purchases. You’ll get funds to replace your old mortgage, and you’ll also get additional cash you can use to pay off your other debts such as student loans or car loans.
Rate-and-term refinancing, on the other hand, simply switches your old interest rate for a new one. You can only get back less than two thousand dollars in cash back, which is why it’s also called “no cash-out refinancing.”
The one potential drawback with refinancing is that it involves closing costs, typically around 2 – 3% of the loan amount. Thus, refinancing is best if you plan on staying in your home long enough for you to recover these costs (ideally 18 months or more).
Do you plan on staying in your home only for the short term but still want to cash in? Choose a home equity loan since it has fewer closing costs than refinancing.
Home Equity Line of Credit vs. Home Equity Loan
Finally, let’s look at home equity lines of credit or HELOC.
As the name suggests, HELOC is another type of home equity loan that works roughly the same way with the same risks and benefits. You also put up your house’s equity as collateral when you take out this type of loan.
The main difference between home equity line of credit vs. mortgage home equity loans is how you’ll get the funds. With HELOC, you can access funds on an “as-needed” basis through a credit line. This is very different from home equity loans, which give one lump sum payment to the borrower.
A HELOC is divided into two parts – the draw and repayment period. During the draw period, you can borrow as many funds as you need so long as you don’t exceed your credit limit. You still need to make loan payments, but they tend to be minimal (similar to a credit card).
Once the repayment period kicks in, you can no longer withdraw money from a HELOC. Your focus now is to repay the funds you borrowed during the draw period. The minimum payment amount ramps up significantly during this time.
HELOC is beneficial because it ensures you only borrow the money you need, potentially lowering your interest payments. However, the trade-off is that it has a variable interest rate and minimum payment, which can increase or decrease throughout the HELOC term.
Which Option is Best For You?
Even though we’ve outlined different options for you, choosing the best financing route can still be challenging. Loan decisions vary for each borrower depending on your goals and situation. However, a few rules of thumb can help steer you in the right direction.
Mortgage: For General Home Buying Needs
For most home financing needs, your typical mortgage should be enough. They provide simple rules; you have fixed monthly payments for a specified period. For first-time house buyers, this is often the best (and usually only) option on the table.
Home Equity Loans: For Big Life Expenses
Do you need additional funds for a significant life purchase? If you have the equity for it, choose a home equity loan vs. mortgage. They have lower interest rates than any other consumer loan, saving you money in the long run.
Refinancing: For Lowering Your Interest Rates
Some homeowners simply want to lower the interest rate on their original, long-term mortgage. If this is you, consider refinancing. Rate-and-term refinancing, in particular, is straightforward to do.
HELOC: For Flexibility and to Prevent Overspending
If you prefer flexibility since you don’t know the exact amount you need to borrow, consider a HELOC vs. mortgage or other “lump sum” type loans. For example, this option is useful if you’re planning to do numerous small home renovation projects, but you’re unsure how much each project will cost. HELOC helps avoid over-borrowing while ensuring you have access to additional funding.
Discover How Reali Can Help
At the end of the day, figuring out how to finance your home is still a tricky proposition. That’s why it’s best to work with a professional who can give you expert advice and guidance.
At Reali, our seasoned agents can help you navigate the world of home loans and mortgages to find the best solution that fits your goals and budget. Contact us today to learn more.