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

Taking out a second mortgage or home equity loan allows homeowners to tap into the equity they’ve built up in their homes. But while a home equity loan is a type of second mortgage not all second mortgages are home equity loans. Understanding the key differences can help you determine which option may be better suited for your financial situation and goals.

What is a Second Mortgage?

A second mortgage is any additional mortgage taken out on a property that already has an existing or “first” mortgage. The home serves as collateral for the second mortgage, meaning if you default, the lender can foreclose and take possession of the home.

Second mortgages generally have higher interest rates than first mortgages since they represent increased risk for lenders. If you default, the first mortgage lender gets paid before the second. So second mortgage lenders need to offset this risk.

What is a Home Equity Loan?

A home equity loan allows you to borrow against the equity or market value you have built up in your home. For example, if your home is worth $300,000 and you owe $180,000 on your mortgage, you have $120,000 in equity.

With a home equity loan, you receive the loan amount in one lump sum payment. Repayment terms are usually between 5-30 years, with interest rates either fixed or variable. Home equity loans are secured by your home, meaning it serves as collateral.

Key Differences Between Second Mortgages and Home Equity Loans

While home equity loans are a type of second mortgage, there are some key differences between the two:

• Interest rates – Home equity loans often have fixed rates while second mortgages can have fixed or variable rates.

• Payments – Home equity loans provide funds in a lump sum while second mortgages like HELOCs allow you to access funds as needed.

• Uses – Second mortgages are more flexible in what funds can be used for while home equity loans tend to be for major expenses like home repairs.

• Collateral – Both use the home as collateral if borrowed against home equity. But second mortgages don’t have to be – you could use a different property.

• Risk – Second mortgages pose a bit more risk for borrowers as the lien is subordinate to the first mortgage.

Pros and Cons of Second Mortgages

Second mortgages have advantages and disadvantages to weigh:

Pros

• Provide access to your home equity for various uses
• Typically have lower rates than other financing options like personal loans or credit cards
• HELOCs offer flexibility in borrowing only what you need
• Interest may be tax deductible if used for home improvements

Cons

• Higher rates than first mortgages
• Monthly mortgage payments increase
• Risk losing home if can’t repay loan
• Rates can fluctuate making repayment costs uncertain

Pros and Cons of Home Equity Loans

Home equity loans also come with pros and cons:

Pros

• Fixed rates provide predictability
• Lump sum distribution allows you to fund large expenses
• Rates are often lower than other financing options
• Can consolidate higher interest debts

Cons

• Monthly mortgage payments increase
• Closing costs can be 2-5% of loan amount
• Risk losing home as collateral if payments missed
• Overborrowing can be temptation with lump sum

Which Option is Better – Second Mortgage or Home Equity Loan?

Determining which is better depends on your unique situation and financial goals. Here are some key factors to help decide:

• If you need funds for a major expense like home renovations, a home equity loan may be preferable since you get a lump sum.

• If you need funds for various uses over time, a HELOC second mortgage provides flexibility to access funds as needed.

• If you want to consolidate high interest debt, a home equity loan with fixed rates can provide stability.

• If you are concerned about rate fluctuations, a home equity loan locks in a fixed rate while HELOCs have variable rates.

• If you have concerns about borrowing more than needed, a home equity loan distributes a set amount while HELOC allows you to draw as needed.

• If you have limited equity and already have a first mortgage, a HELOC may pose less risk than borrowing a lump sum.

When Does a Second Mortgage Make Sense?

Here are some situations where a second mortgage could be a good option:

• You need funds for home repairs and improvements
• You want to consolidate higher interest debts
• You need access to funds for various uses over time
• You want to tap equity to buy an additional property
• You need to finance a major purchase or life event

Just make sure your monthly budget allows you to manage an additional mortgage payment. And have a plan for repayment as second mortgages increase risks if you default.

When Does a Home Equity Loan Make More Sense?

Some situations when a home equity loan may be preferential:

• You need a set amount of funds for a specific one-time expense
• You want the stability of a fixed interest rate and fixed monthly payments
• You need a lower interest rate to consolidate credit card or other high interest debt
• You want funds for a major home renovation project
• You are using funds for home improvements that allow tax deductible interest

The lump sum distribution and fixed rates can provide more structure than a line of credit. But be cautious borrowing more than absolutely needed.

Tips for Getting a Second Mortgage or Home Equity Loan

If you decide a second mortgage or home equity loan is the right choice, here are some tips to get the best rates and terms:

• Shop around and compare offers from multiple lenders
• Check your credit score and report for any errors to correct before applying
• Reduce other debts and credit card balances before applying
• Be prepared to provide income verification and home appraisal documentation
• Choose the shortest repayment term you can afford to pay debt faster
• Opt for fixed rates when possible to lock in stable payments
• Only borrow what you realistically need for your intended purpose

The Bottom Line

Tapping home equity can provide funds for major expenses, debt consolidation, and more. While a home equity loan is a type of second mortgage, there are key differences between the two. Being clear on your financial goals can help determine if a lump sum home equity loan or flexible HELOC second mortgage better suits your needs. Evaluate the risks and costs carefully and have a repayment plan in place.