Mortgages vs. Home Equity Loans: An Overview
Mortgages and home equity loans are both loans in which you pledge your home as collateral. The lender can seize your home if you don't keep up with your mortgage payments. While the two loan types share this important similarity, differences exist between the two. Consumers should understand their options when borrowing against their home’s value.
- Mortgages and home equity loans are both loans in which you pledge your home as collateral.
- The bank lends up to 80% of the home’s appraised value or the purchase price, whichever is less.
- A home equity loan is secured by the equity in the property.
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, if you’re buying a $200,000 home, you are eligible for a mortgage of up to $160,000. You must come up with the remaining $40,000 on your own. Some mortgages, for example, FHA mortgages, allow you to put down less, as long as you pay for mortgage insurance.
The interest rate on a mortgage can be fixed (the same throughout the term of the mortgage) or variable (changing every year, for example). 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 you get behind on payments, the lender can take over your home in a process known as foreclosure. The lender then sells the home, often at an auction, to recoup its money. Should this happen, this mortgage (known as the "first" mortgage) takes priority over subsequent loans made against the property, such as a home equity loan (sometimes known as a "second" mortgage) or home equity line of credit (HELOC). The original lender must be paid off in full before subsequent lenders receive any proceeds from a foreclosure sale.
Home Equity Loans
A home equity loan is also a mortgage. The difference between a home equity loan and a traditional mortgage is that you take out a home equity loan after you have equity in the property, while you get 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, if you owe $150,000 on a home valued at $250,000, you have $100,000 in equity. Assuming your credit is good, and you otherwise qualify, you can take out an additional loan using that $100,000 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.
Your loan-to-value (LTV) ratio is used by lenders to figure out how much money you can borrow. Here's how you compute an LTV: Add the amount you want to borrow to the amount you still owe on your house and divide by the appraised value of the house to get your LTV. If you are in the position of having paid down a good deal of your mortgage—or if your home’s value has significantly risen—you could get a sizable loan.
In many cases, a home equity loan is considered a second mortgage, as 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. These loans may have higher interest rates but lower closing costs—just an appraisal, for example.
The difference between a home equity loan and a traditional mortgage is that you take out a home equity loan after you have equity in the property versus getting a mortgage to purchase the property.
Mortgage vs. Home Equity Loan: Know What's Tax Deductible
Interest on a mortgage is tax-deductible for loans of up to either $1 million (if you took out the loan before December 15, 2017) or $750,000 (a loan after that). The reason: the 2017 tax legislation. Homeowners used to be able to deduct the interest on a home equity loan or line of credit no matter how they used the money, for example, to pay off higher interest debt, such as credit card debt or student loans. Going forward, the Tax Cuts and Jobs Act of 2017 suspends the deduction for interest paid on home equity loans from 2018 through 2025 unless they are used to "buy, build, or substantially improve the taxpayer’s home that secures the loan."
As the IRS puts it, “Under the new law...interest on a home equity loan used to build an addition to an existing home is typically deductible, while interest on the same loan used to pay personal living expenses, such as credit card debts, is not...As under prior law, the loan must be secured by the taxpayer’s main home or second home (known as a qualified residence), not exceed the cost of the home and meet other requirements.”
If you do need to pay off student loans, consolidate credit card debt, or reduce your interest rate on your home mortgage, you should consider refinancing your mortgage.
The Bottom Line
If you have an extremely low interest rate on your existing mortgage, you probably should leave it alone and use a home equity loan to borrow the additional funds you need, provided they are for the purposes of improving your property. However, if mortgage rates drop substantially after taking out your existing mortgage or if you need the money for purposes unrelated to your home, you should consider a full mortgage refinance. If you refinance, you save on the additional money you borrow, as traditional mortgages carry lower interest rates than home equity loans, and you may be able to secure a lower rate on the balance you already owe.