Mortgages and home equity loans both allow borrowers to use their homes as collateral. However, they have some significant differences. For one, to get a home equity loan a borrower already must own a home and, furthermore, must have sufficient equity in the home. A traditional mortgage, also known as a purchase mortgage, is used to buy a property. Also, the proceeds of traditional mortgages generally can only go to buying a house. On the other hand, funds from a home equity loan can be for any purpose.
A financial advisor can be an invaluable resource as you make decisions about financing your residence.
What Is a Mortgage?
A purchase mortgage used to buy a house typically has a fixed interest rate and set payments that last for 30 years. Some mortgages may have adjustable interest rates or different terms, such as 10 or 15 years.
In order to get a mortgage, homebuyers must make a down payment of 3% to 20% of the home’s purchase price. Most buyers put down 6% or less. And some government-backed loans, such as VA loans, require no down payment.
The monthly payment for a purchase mortgage combines several types of payments. Part of the payment goes to pay the interest. Part is applied to the principal balance. Some usually goes into an escrow fund that the mortgage servicing company uses to pay for property taxes and hazard insurance coverage. Some loans may require a private mortgage insurance premium as well.
The part applied to principal eventually pays off the loan completely. Principal payments also increase the buyer’s equity in the property.
How a Home Equity Loan Works
Someone who already owns a home, including owners who are paying on a mortgage, may be able to take out a home equity loan. This type of loan doesn’t require a down payment, but borrowers do have to have enough equity in the home to meet the home equity lender’s loan-to-value (LTV) requirements.
LTV is calculated by dividing the total amount owed on a property by its purchase price. The result is expressed as a percentage. So a $400,000 home with a $200,000 purchase mortgage would have a 50% loan-to-value ratio.
Home equity lenders typically are willing to lend enough to bring the total indebtedness of the property up to 80%. In this case, 80% of $400,000 is $320,000. Subtracting the $200,000 owed on the purchase mortgage produces $120,000. This is the largest amount a home equity lender is likely to lend on this home.
Home equity loans normally have set monthly payments and shorter terms, such as five to 15 years. Like a purchase mortgage, a home equity loan is secured by the home itself. That means if a borrower fails to make the required payment on either purchase mortgage or home equity loan, the lender could repossess the home and sell it.
A home equity loan in this case is a second mortgage. That means if the homeowner defaults on the loans, the first mortgage holder has first right to the proceeds of foreclosure. Because this makes second mortgages riskier, home equity loans normally charge more interest than purchase mortgages. If a homeowner owns the home free and clear without a mortgage, the home equity loan would be a first mortgage.
Borrowers often use home equity loan proceeds to consolidate credit cards and other loans that have higher interest rates. Home equity loans also can help pay for college tuition, wedding expenses and other big-ticket items. They also have set monthly amounts, which can make budgeting easier.
Home equity loans offer low-cost ways to pay for large expenses and consolidate debts. However, since the borrower’s home is a risk, you need to be cautious with them.
Alternatives to Mortgages and Home Equity Loans
One alternative to using a mortgage to purchase a home is to pay with cash. However, with average home prices reaching $362,600 in November 2021, according to national estimates from the National Association of Realtors, paying with cash is not an option for most home buyers.
Some other options to conventional mortgages include rent-to-own arrangements. These deals call for renters to pay an extra amount with their monthly rent, which goes into an account to help fund the needed down payment for a traditional mortgage. Some buyers might be able to borrow from a retirement account, get a loan from a family member or borrow against a cash-value insurance policy.
A home equity line of credit (HELOC) is another alternative to a home equity loan. Unlike a home equity loan, HELOC funds don’t come as a lump sum. Instead, the borrower gets a credit line that the borrower can tap into. This way, the borrower pays only for money that actually comes out of the credit line.
A cash-out refinance also lets a homeowner tap into equity. However, rather than using a second mortgage, the cash-out refinance replaces an existing mortgage with a new loan. The borrower can borrow more than is necessary to pay off the old mortgage and this cash can go to other purposes. One advantage of a cash-out refinance is that the borrower will have only a single payment rather than one for the purchase mortgage and another for the home equity loan.
A reverse mortgage is another type of loan a home can secure. These loans are only for people 62 and over, and they can help seniors with cash flow and other purposes. Rather than the borrower getting a lump sum and then making payments, with a reverse mortgage the lender sends monthly payments to the borrower. When the borrower dies, the lender can foreclose on the home.
Both mortgages and home equity loans let people borrow money using a home as collateral. Traditional mortgages are for purchasing a home, while home equity loans allow people who already own homes tap into equity. Proceeds of a traditional mortgage usually can only be for buying the home, while home equity loan funds can be for any purpose. Both loans require a home as security, and failing to repay either can lead to foreclosure.
Tips on Mortgages and Home Equity Loans
- Consider working with a financial advisor as you assess various ways to use the equity in your residence. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Your mortgage debt can play a significant role in the way you plan retirement. That’s why one of your most useful tools is a free mortgage calculator.
- Mortgage rates are more volatile than they have been in a long time. Check out SmartAsset’s mortgage rates table to get a better idea of what the market looks like right now.
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