Mortgage Loan vs Home Equity Loan: Which is Better for You?

If you’re a homeowner looking to tap into your home’s equity, you may be debating between a mortgage loan and a home equity loan. Both allow you to access your home’s equity but they work differently. In this article I’ll compare mortgage loans vs home equity loans, so you can decide which option is better for your financial situation.

What is a Mortgage Loan?

A mortgage loan is primarily used to purchase or refinance a home. It’s a long-term loan, usually 15-30 years, that’s repaid in monthly installments.

With a mortgage, you’ll make regular payments including principal and interest to pay off the loan over time. The home acts as collateral for the loan, meaning if you default, the lender can foreclose and take possession of it.

There are a few common types of mortgage loans:

• Conventional loans from private lenders, which often require a down payment of at least 20%
• FHA loans insured by the Federal Housing Administration, which allow down payments as low as 3.5%
• VA loans for veterans, active military, and their families with no down payment required
• USDA loans for low-income borrowers in rural areas, also with 100% financing available

What is a Home Equity Loan?

A home equity loan is another way for homeowners to leverage their equity to access cash. But unlike a mortgage, a home equity loan is borrowed against your existing home equity.

It’s considered a second mortgage because it’s separate from your first mortgage. You’ll make principal and interest payments on the home equity loan in addition to your regular mortgage payments.

Home equity loans allow you to borrow up to 85% of your home’s value minus what you owe on your first mortgage. The loan amount is dispersed to you in a lump sum at closing.

Then you’ll repay the principal and interest in fixed monthly installments over a set repayment term, usually 10-20 years. Home equity loans typically have higher interest rates than first mortgages.

Key Differences

Here are some key differences between mortgage loans and home equity loans:

• Purpose: Mortgages finance home purchases, while home equity loans access equity for other uses.

• Payments: A mortgage is your only loan payment. Home equity loans have payments in addition to your existing mortgage.

• Interest rates: Mortgages usually have lower rates than home equity loans.

• Amount borrowed: You can borrow up to the home’s value with a mortgage, but only up to 85% of the value minus your mortgage balance for a home equity loan.

• Closing costs: Closing costs are typically lower for home equity loans than mortgages.

• Tax deductions: Interest on both loans may be tax deductible if you itemize deductions.

Pros and Cons of Each Option

Mortgage Loan Pros

• Lower interest rates
• Only one monthly payment
• Access up to 100% of home value (with some loans)
• Fixed rates provide predictability

Mortgage Loan Cons

• Requires refinancing existing mortgage
• Higher closing costs
• Lengthy loan term accrues more interest
• Prepayment penalties may apply

Home Equity Loan Pros

• Access cash without refinancing mortgage
• Generally lower closing costs
• Shorter repayment terms accrue less interest
• No home purchase needed to qualify

Home Equity Loan Cons

• Higher interest rates
• Additional monthly payment
• Loan amounts limited to 85% of equity
• Variable rates may increase payments

As you can see, each loan has tradeoffs to consider. Think about your goals, finances, and current mortgage when deciding which option may work better in your situation.

When to Choose a Mortgage Loan

Here are some instances when a mortgage loan may be the better choice:

• You want to purchase a new home or investment property
• You’re looking to refinance your existing mortgage at a lower rate
• You need to borrow close to your home’s full value
• You want just one monthly payment
• You qualify for a very low mortgage rate

For example, if rates have dropped significantly since you got your current mortgage, refinancing through a new mortgage loan could help you secure a lower rate and reduce your payments.

When to Choose a Home Equity Loan

A home equity loan may make more sense in these situations:

• You want to access equity without refinancing your existing mortgage
• You have a lot of equity available but owe little on your first mortgage
• You have a low mortgage rate you want to keep
• You need a shorter repayment term to save on interest
• You need funds for a specific purpose like home improvements

For instance, if you have a low mortgage rate and 20 years left on your term, a home equity loan would allow you to tap equity while keeping your affordable first mortgage intact.

Which Option is Right for You?

There are valid reasons to choose either a mortgage loan or home equity loan depending on your unique situation. Here are a few tips for deciding:

• Consider your financial goals, credit score, income, and current mortgage details
• Shop around and compare mortgage vs. home equity loan rates
• Calculate the costs for each option over the full repayment term
• Make sure you can afford the additional payment if you get a home equity loan
• Think about whether you’d benefit more from lower rates (mortgage) or flexibility (home equity loan)

I’d recommend speaking with a loan officer as well. They can assess your finances and mortgage eligibility to help determine if a mortgage refinance or home equity loan better suits your needs.

The right loan comes down to aligning your borrowing needs with the option that will save you the most money in the long run. Evaluating mortgage loans vs. home equity loans based on your own circumstances will lead you to make the optimal decision.