Home Equity Loan vs. Mortgage: How They Differ and What Similarities They Share

Although home equity loans and mortgages are two completely different loan types, many people still confuse them. Both a home equity loan and a mortgage use your property as collateral. That's where their similarities end. Let's compare a home equity loan vs. mortgage and find out how these two work.

What Is a Home Equity Loan?

A home equity loan is a borrowing option that can provide you with extra money for various life projects by using the equity you own in your home as collateral. To get this loan, you need to already be a homeowner with a significant part of the equity in your real estate.

This type of loan is also known as a second mortgage. This is because you can get it even if you still pay your current mortgage. This way, you'll have two debts to pay at a time.

How Does a Home Equity Loan Work?

A home equity loan uses what you already own in your home as collateral. In exchange, it provides you with a portion of equity you own in the form of a lump-sum direct deposit into your bank account. The amount you get can be used for various personal needs, so there's no specific loan purpose set.

An interest rate applied to a home equity loan is usually fixed. This means that it doesn't change within the entire loan duration. Additionally, an APR on this type of borrowing is usually lower than that of a regular personal loan option.

Home equity loans need to be repaid in affordable monthly installments. The repayment terms are usually between 5 and 30 years. Thanks to this, you can adjust your monthly payment amount to your budget by choosing a shorter or longer repayment period.

What Maximum Loan Amount Can I Get with A Home Equity Loan?

In most cases, lenders can offer you up to 80-85% of your home's value minus the amount you still owe on your mortgage. Suppose that your house costs $500,000, with the outstanding mortgage balance equaling $200,000. To calculate the maximum amount you can get, you need to:

- Multiply the market price of your house by 0.85 to determine how much 85% of your home's value will be: $500,000 * 0.85 = $425,000.
- Deduct the amount you still owe on your mortgage from the result you get: $425,000 - $200,000 = $225,000.

At the same time, a lender will also take into account your monthly income to make sure you can afford the requested debt. Additionally, your credit score can also affect the maximum loan amount a lender can give you.

Pros and Cons of Home Equity Loans

Below are some advantages and drawbacks of home equity loans. Consider them before going into debt to make sure this borrowing option is right for you.

Pros:

- Significant loan amounts are available. If you need extra money for some major life projects, a home equity loan can help you cover your needs. As the amount you can get is calculated on your property's cost, it can be much higher than the sum you can get with an unsecured personal loan;
- No specific loan purpose is set. Home equity loan amount can be used to cover any of your personal needs. Whether there are vacation costs, medical expenses, or home improvement, it can get you covered;
- No interest rate fluctuation. A home equity loan is typically a fixed-rate loan. This means that your interest rate will be the same within the whole repayment period. This also helps at the budgeting stage due to the predictability of your monthly payments;
- Affordable rates and fees. A home equity loan is usually cheaper than most other loan options because of the collateral provided. This results in less overpayment in the long run;
- Flexible repayment terms. Depending on your current financial situation and needs, you can choose a repayment period of anywhere between 5 and 30 years. This way, you can regulate your monthly payment, making it more manageable;
- It can reduce your tax burden. In some situations, home equity loan interest paid can be deducted from your taxable income. To make it possible, you need to confirm that the amount you get was used for home renovation or home improvement.

Cons:

- If you already have a current mortgage, a home equity loan will increase the financial burden. This is because you'll have to make two loan payments each month, and both of them can be quite high;
- You need to already own a significant equity in your home. Most lenders require your combined loan-to-value ratio to be no more than 80-85%. This means that the sum of all your existing loans on the property must not exceed 80-85% of your house's value;
- Strict credit score requirements. Although a home equity loan is a secured debt, most lenders still set minimum credit score requirements that a borrower must meet to qualify. Typically, you can get a home equity loan only if your credit score is at least 680;
- You'll have to pay closing costs. When it comes to loans on property, most lenders apply closing costs. They can be between 2% and 5% of the requested sum, which is quite significant due to the high loan amounts available;
- Risk of losing your property. Home equity loans are risky for borrowers. If you miss your loan payments for about 3-6 months, the lender can start a foreclosure process and repossess your home. Then, your property will be sold, and the amount will be used to cover your unpaid debt.

What Is a Mortgage?

A mortgage is a specific-purpose loan. It can be used for purchasing real estate only. This means that you won't get the money on hand. If approved, a bank or credit union will transfer the mortgage amount directly to a home seller. To get a mortgage, you need to already choose the house you want to purchase. This house will also serve as collateral, meaning that a lender will be able to seize it in case of regular problems with your loan payments.

How Does a Mortgage Work?

A bank or a credit union can finance up to 100% of your home's value. However, 100% financing is available only with some government-backed programs or under the family-deposit mortgage. This means that, in most cases, you will be asked to provide a down payment. Its amount depends on your income and credit score, but the minimum is usually 10-20% of your house's market price.

A mortgage can be either a fixed-rate or a variable-rate debt. While a fixed interest rate comes with stability and predictability, a variable rate can fluctuate under certain economic conditions. However, a variable-rate loan is usually cheaper.

Commonly, a mortgage must be repaid over up to 15, 20, or 30 years. You make loan payments on a monthly basis by the set date.

Home Equity Loans vs. Mortgages: Which One Should I Choose?

The answer to this question generally depends on your loan purpose. If you're a homeowner who needs more money for personal needs, a home equity loan is a perfect fit. If you're going to purchase a new house, a mortgage will suit you better, even if you already own another real estate. This is because a conventional mortgage usually has lower interest rates.

Other Options to Consider

Here are some alternatives available if you're looking for a way to get extra cash for your personal needs.

Cash-Out Refinance

A cash-out refinance is a type of borrowing that can replace your primary mortgage and leave you extra cash on hand. It becomes possible as a lender provides you with a new loan with a higher amount than the sum you owe on your mortgage. This can be a more budget-friendly option as it leaves you with only one loan to pay but still provides you with extra cash for your personal needs. Also, the new loan can come with lower interest rates, reducing the amount you pay each month.

Home Equity Line of Credit (HELOC)

A home equity line of credit (HELOC) is a flexible solution for people who need money just in case or want to save on interest. HELOCs are quite similar to regular credit cards. They provide borrowers with revolving lines of credit, with interest applied to only the amount they actually use.

Another great HELOC feature is its draw period. This period usually lasts up to 7 or 10 years. Within this term, you can only pay interest without repaying the principal amount you spend. After this interest-only period ends, there comes a repayment period, which lasts up to 20 years. Within the repayment period, you can't use the money anymore.

Unsecured Personal Loan

An unsecured personal loan is a less risky way to get financial assistance. As the name suggests, this type of loan comes with no repayment guarantee. You should only have a good-enough credit score and sufficient income to qualify. Unsecured personal loans can provide you with up to $100,000 for up to 60 months. However, an interest rate will be higher compared to secured options.

Bottom Line

Although both a home equity loan and a mortgage use the property you own as collateral, they are pretty different. A mortgage is a loan for a specific purpose that allows you to purchase real estate. A home equity loan is a form of secured personal loan that provides cash for personal needs by using the equity you own in your house as a repayment guarantee. Thus, to understand which loan type you should choose, you need to determine your loan purpose.