It’s no secret – having a considerable amount of home equity has its perks. You get peace of mind knowing you can sell at a profit when the time comes. And if you decide to stay put, you can potentially leverage your equity to meet your financial goals.
Choosing to do the latter could mean applying for a home equity loan or another type of second mortgage.
Introduction to Home Equity Loan vs Second Mortgage
Here’s a closer look at what to know about home equity loans and second mortgages, along with examples to help you distinguish between the two.
What is a Home Equity Loan?
A home equity loan is a type of second mortgage that uses your home as collateral. The amount you’re eligible for is based on the amount of equity in your home, and the amount you borrow is paid in equal monthly installments. If you default on the agreement, you could lose your home to foreclosure.
Example of a Home Equity Loan
Lenders generally offer 80 to 85% equity through these loan products. So, if your home is worth $400,000 and you owe $250,000 on your mortgage, you could get approved for a home equity loan between $70,000 ($400,000 * .80 – $250,000) and $90,000 ($400,000 * .85 – $250,000).
This range is based on the loan-to-value (LTV) ratio that lenders use to determine how much equity you can borrow against. It’s important to maintain a good credit score and a manageable debt-to-income (DTI) ratio to qualify for these loans. Furthermore, having at least 15% equity in your home is typically required. This ensures that you are not over-leveraged and can comfortably manage the additional debt payments each month.
What is a Second Mortgage?
As the name suggests, a second mortgage is an additional home loan that you can take out on top of your current one. It’s also based on your home’s value and uses your home as collateral. This type of loan allows homeowners to access the equity they have built up in their property without refinancing their first mortgage.
Example of a Second Mortgage
Beyond home equity loans, home equity lines of credit (HELOCs) are also categorized as second mortgages. Instead of being provided with a lump sum of cash at closing, you get access to the same amount on an as-needed basis through withdrawals. Similar to a credit card, you only pay interest on the amount you borrow, but payments could fluctuate since the interest rate is variable.
Piggybank loans are another form of second mortgage. They are typically used in conjunction with a primary mortgage to purchase a home and avoid primary mortgage insurance (PMI), which is required if you put down less than 20%. You can also use a piggyback loan to steer clear of having to take out a jumbo loan.
Is a Second Mortgage the Same as a Home Equity Loan?
As previously mentioned, a home equity loan is a type of second mortgage. However, a HELOC or piggyback loan could be ideal if a home equity loan isn’t a good fit for your financial situation.
Common Grounds Between Home Equity Loan vs Second Mortgage
Both are secured by your home, but there are key differences in repayment periods, loan caps and disbursement methods.
Differences Between Home Equity Loan vs Second Mortgage
This section focuses on the variances between home equity loans and the most common other type of second mortgage – the HELOC.
Interest Rates
- Home equity loan: You’ll typically get a fixed rate, which gives you predictable monthly loan payments.
- Second mortgage (HELOC): Expect a variable interest rate that fluctuates with market conditions during the draw and repayment period.
Repayment Period
- Home equity loan: You get a set repayment period, typically spanning from five to 15 years.
- Second mortgage (HELOC): There’s a draw period during which you can access funds – generally up to 10 years – followed by a repayment period of up to 20 years. You only pay interest during the draw period, but principal and interest are collectible once it ends.
Loan Amount Limitations
- Home equity loan: The cap on home equity loans is around 80 to 85% of your home’s equity.
- Second mortgage (HELOC): Like home equity loans, most lenders limit HELOCs to no more than 85% of your home equity.
Loan Disbursement
- Home equity loan: You receive the loan proceeds in a lump sum following closing.
- Second mortgage (HELOC): You get access to a revolving line of credit that works like a credit card.
Tax Benefits
- Home equity loan: Loan proceeds used to substantially repair or improve your home could be tax deductible.
- Second mortgage (HELOC): The same perks extend to HELOCs, but it’s worth consulting with a tax advisor to learn more.
When to Consider Home Equity Loans
A home equity loan could be a good fit if you have a set expense in mind, like a big-ticket purchase or debt consolidation.
Pros and Cons of Home Equity Loans
Pros:
- You get the funds in a lump sum payment to use right away.
- Fixed interest rates give you a predictable monthly payment.
- You can use the loan proceeds however you see fit.
- You can pay the loan off early and save in interest if there are no prepayment penalties.
Cons:
- Your loan amount may not be as big as you intended if the appraisal comes in low.
- Your home equity could also minimize your loan amount.
- Interest is assessed on the total amount you borrow.
- You could lose your home if you fall behind on payments.
When to Consider Second Mortgages
A HELOC could be ideal if you need ongoing access to a pool of cash to use as an emergency cushion or to fund a long-term renovation project.
Pros and Cons of Second Mortgages
Pros:
- You’re free to borrow as much or as little as you need.
- The lengthy draw period gives you enough time to cover long-term expenses.
- Interest is only assessed on the amount you borrow.
Cons:
- The interest rate is variable, which means monthly payments will fluctuate.
- You’ll pay closing costs to seal the deal.
- Your home secures the HELOC, so falling behind on payments could mean foreclosure.
How to Apply for a Home Equity Loan or Second Mortgage
If you decide on a home equity loan, here’s how to move forward:
- Step 1: Confirm you have an adequate amount of home equity.
- Step 2: Check your credit to ensure it’s strong enough to qualify for a HELOC or second mortgage.
- Step 3: Compare lenders to determine which offers the best deals on home equity loans.
- Step 4: Create a shortlist of lenders and get pre-qualified to identify your top pick.
- Step 5: Formally apply with the lender you select and submit the required documents promptly to ensure your application is processed in a timely manner.
- Step 6: Wait for the home appraisal results, and then review the loan documents.
- Step 7: Sign the loan agreement and receive your loan proceeds shortly after.
Conclusion: Deciding Between Home Equity Loan vs Second Mortgage
Deciding which option is best to access your home equity comes down to your unique needs, goals and financial situation. Home equity loans offer more predictability regarding interest rates and monthly payments. At the same time, HELOCs come with variable rates that could make it more challenging to budget for monthly payments as rates fluctuate over time.
Evaluate each option and run the numbers to decide which is best. Most importantly, shop around to find the best deal and ensure either of these mortgage mortgages work for your finances.
Frequently Asked Questions on Home Equity Loan vs Second Mortgage
It’s possible to carry a home equity loan and a second mortgage simultaneously. But confirming you have enough equity in your home to qualify for both is vital. It’s equally important to understand that taking out two-second mortgages means you’ll have an increased debt load. And if you fall behind on the loan payments, the lender could seize your property through foreclosure to collect what’s owed.
