Should You Get a Home Equity Loan or Second Mortgage? An In-Depth Comparison

Having equity in your home opens up financial opportunities You can leverage your equity through a home equity loan or second mortgage when you need access to funds But is there really a difference between the two?

I’ll compare home equity loans and second mortgages in detail so you can determine if either option makes sense for your situation. With this comprehensive guide, you’ll understand how they work, the pros and cons and alternatives to consider.

What is a Home Equity Loan?

A home equity loan allows homeowners to borrow against the equity they have built up in the property.

It works like this

• Your home value is determined, often through an appraisal.
• The loan balance remaining on your mortgage is subtracted.
• A percentage of the difference, typically 80-90%, is available to borrow against.

You can qualify to borrow up to 80-90% of your home equity with a home equity loan. The funds are disbursed to you in a lump sum payment that you repay in fixed monthly installments over a set repayment term, usually between 10-20 years.

The interest rate and payments on a home equity loan are fixed. This allows for predictable budgeting as your payment doesn’t fluctuate.

What is a Second Mortgage?

A second mortgage is any additional mortgage loan that is subordinate to the original or first mortgage used to purchase the home. Second mortgages rank below first mortgages in priority.

There are two main types of second mortgages:

• Home Equity Loan – Fixed-rate installment loan
• Home Equity Line of Credit (HELOC) – Revolving line of credit

While first mortgages are typically used to purchase or refinance a home, second mortgages allow you to leverage your equity for other needs. The home serves as collateral for the second mortgage.

Key Differences

While a home equity loan is a type of second mortgage, not all second mortgages are home equity loans. Let’s look at some of the key differences in how they work:

Loan Amount

• Home Equity Loan – Up to 80-90% of home equity
• HELOC – Up to 85-90% of home equity

Interest Rate

• Home Equity Loan – Fixed
• HELOC – Variable

Repayment

• Home Equity Loan – Fixed monthly payments
• HELOC – Flexible payments during the draw period

Predictability

• Home Equity Loan – Set monthly payments
• HELOC – Payments can fluctuate

Use of Funds

• Home Equity Loan – Lump sum
• HELOC – Access funds as needed

While HELOCs offer greater flexibility, home equity loans provide fixed rates and predictable payments. Each have their pros and cons depending on your needs.

Pros of Home Equity Loans and Second Mortgages

1. Access funds without refinancing

Home equity loans and second mortgages allow you to leverage your equity without replacing your existing mortgage. You keep your original loan terms intact.

2. Lower rates than other financing options

Interest rates on home equity loans tend to be lower than rates on credit cards or personal loans. This makes them one of the most cost-effective borrowing options.

3. Shorter approval timelines

You may be able to get approved for a home equity loan in a few weeks. The process is often quicker than refinancing.

4. Fewer qualification requirements

Home equity lending guidelines are more lenient compared to refinancing. You may qualify for a home equity loan with lower credit scores or higher debt-to-income ratios.

5. Interest may be tax deductible

If you use the funds for approved purposes, like home improvements, you may be able to deduct the interest on your taxes.

Cons of Home Equity Loans and Second Mortgages

1. Your home is at risk

Home equity loans use your property as collateral. Not being able to make payments could lead to default and foreclosure.

2. Closing costs

You’ll pay closing costs equal to 2-5% of the loan amount. This reduces the net funds you receive.

3. Rates can rise over time

Home equity loans have fixed rates, but HELOC rates are variable. Increasing interest rates can lead to higher payments.

4. Temptation to overspend

Easy access to funds through HELOCs could encourage you to borrow more than planned or needed.

5. Ongoing payments

A second mortgage adds another monthly payment you are responsible for making. This increases your expenses.

When Does a Home Equity Loan Make Sense?

A home equity loan tends to be the right fit when:

• You need a lump sum of cash
• You want fixed rates and payments
• You plan to keep the loan long term
• You have sufficient income to manage the payments
• You need funds quickly as closing can be fast

Common uses include:

• Home renovations
• Consolidating high-interest debt
• Paying for college
• Covering medical expenses
• Funding a wedding

When Does a HELOC Make More Sense?

A HELOC may better suit your needs when:

• You want to access funds over time
• You want flexibility in payments
• You hope to pay off the balance quickly
• You want funds available for emergencies
• You are covering ongoing expenses

Typical uses include:

• Home repairs and improvements
• Unplanned expenses
• Credit card and other debt consolidation
• College tuition
• Purchasing an investment property

Alternatives to Consider

While home equity loans and HELOCs allow you to access your equity, there are other options:

Cash-out refinance – Replace your mortgage with a larger balance to tap equity.

Personal loan – Unsecured installment loan with set repayment terms.

Credit cards – Revolving credit lines for ongoing expenses.

401(k) or retirement plan loan – Borrow from your own savings (with rules).

Family loan – Borrow from relatives using a promissory note.

Each option has pros and cons to weigh based on your specific needs and financial circumstances.

The Bottom Line

When it comes to home equity loans vs second mortgages, they effectively mean the same thing – borrowing against the equity in your property. While similar, there are some differences between home equity installment loans and HELOC lines of credit.

Consider both the benefits and drawbacks before moving forward with a home equity loan or second mortgage. And compare your alternatives to make sure you choose the most strategic borrowing option for your situation. Leveraging your equity can provide access to funds but should be done carefully.