What Is the Difference Between Mortgages and Home Equity Loans?
Mortgages and home equity loans are both borrowing methods that require pledging a home as collateral, or backing, for the debt. This means the lender can seize the home eventually if you don't keep up with your repayments. While the two loan types share this important similarity, there are also key differences between the two.
- Mortgages and home equity loans are both loans for which the borrower pledges the property as collateral.
- One key difference between a home equity loan and a traditional mortgage is that the borrower takes out a home equity loan when they already own or have equity in the property.
- Lenders generally allow you to mortgage up to 80% of a home's value; the percentage you can borrow via a home equity loan varies depends on how much of the home you own outright.
- The total threshold for tax deductions on all residential debt, be it a mortgage or a home equity loan, or both, is currently $750,000.
Understanding How Mortgages and Home Equity Loans Work
When people use the term “mortgage,” they are generally talking about a traditional mortgage, for which a financial institution, like a bank or credit union, lends money to a borrower to purchase a residence. In most cases, the bank lends as much as 80% of the home’s appraised value or the purchase price, whichever is less. If, for example, a house is appraised at $200,000, the borrower would be eligible for a mortgage of as much as $160,000. The borrower would have to pay the remaining 20%, or $40,000, as a down payment.
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; the most common terms are 15 or 30 years.
If a borrower falls behind on payments, the lender can seize the home, or collateral, 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.
Mortgage lending discrimination is illegal. If you think you've been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps you can take. One such step is to file a report to the Consumer Financial Protection Bureau or with the U.S. Department of Housing and Urban Development (HUD).
Home Equity Loans
A home equity loan is also a mortgage. The main difference between a home equity loan and a traditional mortgage is that you take out a home equity loan after buying and accumulating equity in the property. A mortgage is typically the lending tool that allows a buyer to purchase (finance) the property in the first place.
As the name implies, a home equity loan is secured—that is, guaranteed—by a homeowner's equity in the property, which is the difference between the property’s value and the existing mortgage balance. If you owe $150,000 on a home valued at $250,000, for example, 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 rating helps to inform this decision.
Loan-to-Value (LTV) Ratio
Lenders use the loan-to-value (LTV) ratio to determine how much money an investor can borrow. The LTV ratio is calculated by adding the amount requested as a loan to the amount the borrower still owes on the house and dividing that figure by the appraised value of the house; the total is the LTV ratio. If a borrower has paid down a good deal of their mortgage—or if the home’s value has risen significantly—the borrower could get a sizable loan.
In many cases, a home equity loan is considered a second mortgage—for example, if the borrower has an existing mortgage on the residence already. 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, however. A borrower who owns his property free and clear may decide to take out a loan against the 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—for example, an appraisal might be the only requirement to complete the transaction.
Tax Deductibility of Mortgages and Home Equity Loans
Ironically, home equity loans and mortgages have become more similar in one respect— their tax deductibility. The reason: the Tax Cuts and Jobs Act of 2017.
Before the Tax Cuts and Jobs Act, you could deduct only up to $100,000 of the debt on a home equity loan.
Under the act, interest on a mortgage is tax-deductible for mortgages of up to either $1 million (if you took out the loan before December 15, 2017) or $750,000 (if you took it out after that time). This new limit applies to home equity loans as well: $750,000 is now the total threshold for deductions on all residential debt.
However, there's a catch. 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—be it on home improvements, or to pay off high-interest debt, such as credit card balances or student loans. The act suspended 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."
The IRS states:
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.
The Bottom Line
If you have an extremely low-interest rate on your existing mortgage, you probably should use a home equity loan to borrow the additional funds you need. But keep in mind that there are limits on its tax deductibility, which include using the money for the purposes of improving your property.
If mortgage rates have dropped substantially since you took 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 can 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.