Home equity loans and mortgages are both ways of borrowing against the value of your home. That’s why home equity loans are also sometimes known as second mortgages, but there are also fundamental differences in how these loans work and what they are intended to achieve.
Let’s take a closer look at home equity loans vs mortgages, including what they are, how they work, their similarities, and the important ways in which they differ.
WHAT IS A MORTGAGE?
A mortgage is money that you borrow, usually from a bank and credit union, to buy a residence. This type of loan allows you to take possession of a residence and live in it while you pay off what you have borrowed, plus the interest charged by the lender.
In most conventional mortgages, the buyer is expected to pay for at least 20% of the market price of the home with a down payment. The bank or credit union then extends a mortgage for the remaining 80% of the value of the property plus interest. Conventional mortgages are usually payable over 15 or 30 years.
Your loan is secured against the property itself, meaning that if you fail to pay your loan in a timely way, your lender can seize your home and sell it to recover the money lent. By using the value of your home as collateral to reduce your lender’s risk, home buyers are able to borrow money at a much lower rate of interest.
WHAT IS A HOME EQUITY LOAN?
While your lender remains the effective owner of your home until you finish paying down your mortgage, your stake in the total value of your home continues to grow as you pay more of what you owe. This is known as your equity. A home equity loan allows you to borrow against this equity stake, which also increases in value as the market value of your property rises.
A home equity loan gives you a significant cash payout, borrowed against the equity stake you have built up in your home that you can use for anything you wish and which you repay while continuing to make any outstanding payments on your original mortgage on the same property. Home equity loans are usually payable over 15, 20, or even 30 years.
HOW ARE HOME EQUITY LOANS AND MORTGAGES SIMILAR?
Home equity loans and mortgages are similar in that they are both loans that allow you to borrow against the value of your home. Other similarities include:
FIXED RATES AND PAYMENTS
Both home equity loans and conventional mortgages usually come with fixed interest rates, although “unconventional” adjustable-rate mortgages do reset to a higher rate after a time. With fixed terms, this means your monthly payment remains the same for the life of the loan, even as interest rates rise or fall.
LOWER INTEREST RATES
As secured loans, both home equity loans and mortgages generally offer much lower interest rates than unsecured lending in the form of personal loans or credit cards.
SECURED AGAINST YOUR PROPERTY
Both home equity loans and mortgages use the intrinsic value of your home as a fixed, saleable asset to reduce your lender’s risk. That means you may risk losing your home if you are unable to make payments on either a home equity loan or a mortgage you’ve taken out on a property.
TAX-DEDUCTIBLE INTEREST
Interest payments on both mortgages and home equity loans are potentially tax deductible, subject to certain restrictions.
The deductions only apply to loans or the portions of loans worth up to $750,000. The value of both your outstanding mortgage and the unpaid portion of your home equity loans are added together to get this amount. Your home equity loan also needs to have been used to “buy, build or substantially improve” the home in order for the interest to be tax deductible.
HOW DO HOME EQUITY LOANS AND MORTGAGES DIFFER?
Despite the similarities, home equity loans and mortgages are designed to do very different things. Mortgages are designed to secure a property that you and your family can live in, while home equity loans are designed to free up cash that you have invested in your home without selling or refinancing it.
As a result, home equity loans and mortgages differ in several key ways:
BORROWING FORWARD VS. BORROWING BACK
Mortgages and home equity loans are often paid off at the same time, but they work in very different ways. A mortgage is taken out when you buy the home and essentially allows you to borrow against the value you will invest in your home in the future.
A home equity loan is taken out after you have been in the home for a while and taps into the equity you have already built up.
BUILDING EQUITY VS. PAYING OFF DEBT
Put another way, the payments you make on a mortgage go towards building more equity in your home until your loan is paid off. Any increase in the market value of your home will increase the value of your equity. Payments on a home equity loan go to repay debt but do not directly increase your equity stake.
INCREASING EQUITY VS. LUMP SUM PAYOUT
You will also not see the value of the equity you have built up by paying off your mortgage until you sell your home. The real value is the ability to live in your home and improve it while paying it off. A home equity loan pays out as actual cash in hand to use as you please.
SINGLE USE VS. FLEXIBLE USE
Similarly, the money you borrow for your mortgage has only one use—to secure you an increasing stake in a fixed asset (and a place to live). On the other hand, the cash you borrow against the equity in a home equity loan can be used for anything you please.
The most effective and tax-efficient way to use a home equity loan is to reinvest the money into the value of your home through improvements and upgrades. In reality, however, people use home equity loans to pay for college, consolidate debts, or even to buy other properties.
LOAN-TO-VALUE RATIOS
A mortgage also allows you to borrow far more of the value of your home—and before you have begun to pay it off! Conventional mortgages allow you to borrow up to 80% of the value of your home (more for FHA- and VA-backed loans) once you’ve made a 20% down payment.
By contrast, a home equity loan will usually only allow you to borrow against 80-85% of the equity stake you have built so far in your home. Most lenders will also not consider extending a home equity loan until you have paid off at least 15-20% of the value of your home.
DEBT-TO-INCOME RATIOS
On the other hand, lenders are often more generous in determining the amount you can borrow relative to your income for a home equity loan, compared with a mortgage. For many mortgages, especially a first mortgage, lenders will look for a debt-to-income ratio ideally below 36% to ensure a buyer is able to continue to make regular payments.
Home equity loans are significantly smaller than mortgages and borrowers have already demonstrated an ability to make payments and build equity. As a result, lenders are more willing to consider debt-to-income ratios of 45% or above.
SALES AND FORECLOSURES
That said, mortgages and home equity loans are treated very differently in the case of a forced sale or foreclosure. In a conventional home sale, any outstanding liens, such as a home equity loan, are paid off from the proceeds of the sale and any remaining profits go to the seller.
If your home is repossessed and sold below market value because you were unable to make your payments, the proceeds will go to pay off your remaining mortgage balance before the outstanding amount on your home equity loan is paid. You could still owe money after your home is sold, especially if your home equity loan and mortgage are from different lenders.
A FLEXIBLE ALTERNATIVE TO HOME EQUITY LOANS
Home equity lines of credit (HELOCs) offer another way to tap the equity you have built up in your home but without the risk and long-term commitment that comes with a lump sum payout from a home equity loan.
Instead, a HELOC offers you a revolving line of credit against your equity, allowing you to borrow money as you need it and pay it down as you are able. HELOCs offer the ease and convenience of on-tap credit with the low rates and flexibility of fully secured borrowing.
Northern Utah is a great place to put down roots and start a family. If you’re already a homeowner in Weber, Morgan, or Davis counties, then a Wasatch Peaks Credit Union HELOC can help you manage long-term home improvements or unpredictable, ongoing costs like moving expenses or a child’s college tuition.
Our fast and flexible HELOCs offer members:
- Lengthy withdrawal periods
- Loan-to-value ratios according to your mortgage and home value
- Low variable interest rates
Click below to learn more about how applying for a Wasatch Peaks HELOC can help you get even more out of your home.
