Mortgages and home equity loans are both loans in which the borrower pledges his home as collateral. In other words, the lender can seize the borrower's home as recourse for nonpayment. While the two loan types share this important similarity, differences exist between them, and consumers should understand their options when borrowing against their home's value.
When people use the term mortgage, they are generally talking about a traditional mortgage, in which a bank lends a borrower money to purchase a home. In most cases, the bank lends up to 80% of the home's appraised value or the purchase price, whichever is less. For example, a person buying a $200,000 home is eligible for a mortgage of up to $160,000. He must come up with the remaining $40,000 on his own.
The interest rate on a mortgage can be fixed or variable. The borrower repays the amount of the loan plus interest over a fixed term, with the most common terms being 30 or 15 years. If the borrower gets behind on payments, the lender can take over the home in a process known as foreclosure. The lender then sells the home, often at an auction, to recoup its money.
In the event of default, this mortgage takes priority over subsequent loans made against the property, such as home-equity loans or home-equity lines of credit (HELOCs). The original lender must be paid off in full before subsequent lenders receive any proceeds from a foreclosure sale.
Home-Equity Loan Basics
A home-equity loan is also a mortgage. The difference between a home-equity loan and a traditional mortgage is that a borrower takes out a home-equity loan after he already owns the property, while he gets a mortgage to purchase the property. A home-equity loan is secured by the equity in the property, which is the difference between the property's value and the homeowner's existing mortgage balance. For example, a person who owes $150,000 on a home valued at $250,000 has $100,000 in equity. Assuming his credit is good, and he otherwise qualifies, the borrower can take out an additional loan using his home's equity as collateral.
Like a traditional mortgage, a home-equity loan is an installment loan repaid over a fixed term. Different lenders have different standards as to what percentage of a home's equity they are willing to lend, and the borrower's credit plays a part in this decision.
In many cases, a home-equity loan is considered a second mortgage, since it is made on top of an existing mortgage. If the home goes into foreclosure, the lender holding the home-equity loan does not get paid until the first mortgage lender is paid. Consequently, the home-equity loan lender's risk is greater, which is why these loans typically carry higher interest rates than traditional mortgages.
Not all home-equity loans are second mortgages. A borrower who owns his property free and clear may decide to take out a loan against his home's value. In this case, the lender making the home-equity loan is considered a first lien holder.
Mortgage vs. Home-Equity loan
A homeowner wanting to use his home's equity to pay off higher interest debt such as credit cards, or to make home improvements, faces a decision. He can either refinance his entire mortgage balance, plus the additional cash out, with a traditional mortgage, or he can leave his original mortgage alone and take out a home-equity loan on top of it.
Interest rates determine which type of loan is better in this situation. A borrower who has an extremely low interest rate on his existing mortgage should leave it alone and use a home-equity loan to borrow the additional funds he needs. However, if mortgage rates have dropped substantially since the borrower took out his existing mortgage, he should consider doing a full refinance. In the latter case, the borrower saves on the additional money he borrows, since traditional mortgages carry lower interest rates than home equity loans, and he can secure a lower rate on the balance he already owes.