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Take a look at any lender’s website, and you’ll find many options for borrowing money based on a home’s value.
One of those options, a mortgage, comes before ever having a stake in your home, and helps you purchase it. After you borrow the mortgage, that stake in the property becomes your equity, which allows you to borrow more through a home equity loan.
- Both mortgages and home equity loans are secured by property. A mortgage is used to purchase the property, while a home equity loan is used for various expenses — think home improvements, tuition or medical bills.
- Compared to other forms of credit, both a mortgage and a home equity loan tend to offer lower interest rates on larger loan amounts.
- Home equity loans almost always have a fixed interest rate, while a mortgage can have a fixed or variable rate.
- A mortgage is the first lien position on the property, so that lender recoups its losses first in the event of foreclosure. A home equity loan is in the second position, making it riskier for lenders.
Mortgage vs. home equity loan
The key difference is that you use a mortgage to buy a home, while you use a home equity loan for other purposes that might or might not be related to the property. You can only take out a home equity loan after you’ve bought the home, assuming you meet the home equity lender’s qualifying requirements.
The other main difference: The mortgage is in the first lien position, while the home equity loan might be in the second or subsequent lien positions. This means that if the lender were to foreclose, the lender who originated the first mortgage would receive the proceeds of the foreclosure sale first, followed by the lender of the second mortgage and so on. This makes home equity loans a riskier prospect for lenders.
Because both loans can involve a hefty sum of cash, the application and underwriting process feels equally intense, too.
“The process is generally the same between a mortgage and a home equity in that the lender has to evaluate income, employment and appraise the property,” says Vikram Gupta, head of home equity for PNC Bank.
During at least one stage, though, the home equity loan process is faster. “For homes below a certain appraised value — usually under $500,000 — the lender can waive the need for an in-person appraisal and substitute it with other types of valuation tools, which can often be faster and less expensive,” says Gupta.
In addition to saving some time, home equity loans tend to cost less as far as closing costs. “The one caveat is that home equity lenders often charge an early closure fee if the borrower closes their home equity loan early — usually [within] three years,” says Gupta.
However, while you’ll save money on closing costs, rates on home equity loans are typically higher than purchase mortgage rates. That’s because home equity loans are riskier — if you’re in a pinch financially, lenders know you’ll likely prioritize paying your mortgage over a home equity loan. They compensate for this risk by raising the rate.
Similarities between mortgages and home equity loans
- Both loans secured by property
- Both allow you to borrow a relatively large amount
- Both tend to have lower interest rates compared to other types of credit
- Both have qualifying criteria, such as minimum credit score
Differences between mortgages and home equity loans
- A mortgage helps you buy a home, while a home equity loan helps you pay for other expenses after you buy it
- Mortgages have lower interest rates than home equity loans
- Home equity loans have lower closing costs than mortgages
- Mortgages are in the first lien position, while home equity loans are in the second or subsequent position
How does a mortgage work?
A mortgage is a loan to help you to finance a home. Mortgage lenders have requirements you need to meet to be approved for a loan. These typically involve:
- A minimum credit score that shows a history of responsible payments
- A debt-to-income (DTI) ratio that shows you earn enough money to cover other expenses such as a car loan or credit card bill
- A minimum down payment
- Enough cash to cover closing costs on the mortgage
The most common type of mortgage is a 30-year fixed-rate loan, but there are other options for borrowing money for a home, too, such as 15-year fixed-rate loans and adjustable-rate mortgages.
How does a home equity loan work?
A home equity loan comes later in the homeownership journey, while you’re still paying your mortgage or if you’ve already paid it off in full. If you’re in the middle of repaying your mortgage, a home equity loan is a type of second mortgage that allows you to use the equity in your home to borrow more money.
Let’s say your home is worth $300,000, and you owe $125,000 on your first mortgage. You have $175,000 of equity in your home, and you can use that equity as the collateral for a loan. You can borrow up to 80 percent or 85 percent of your equity, depending on your credit profile, the lender you work with and other factors.
“These variables can change depending on whether the home is the primary residence or an investment property and whether the borrower is applying alone or with a co-borrower,” says Gupta.
Home equity loan alternatives
If you’re looking to borrow money but aren’t sure a home equity loan is right for you, you might explore these options:
- Cash-out refinancing: If you’re eligible, you can take cash out of your home while refinancing. This replaces your existing mortgage with a larger one based on your level of equity, allowing you to keep the difference in cash. You can then use that money for any purpose. A cash-out is generally a good idea if you can get a lower interest rate and you know exactly how much money you need.
- Home equity line of credit (HELOC): A HELOC allows you to draw funds from your home’s equity, at the cost of interest, for a certain period of time. After that time, you’ll repay what you borrowed plus any outstanding interest. This might be a better route than a cash-out refinance if you don’t know how much funds you need.
Which loan type is best for you?
The answer depends on what you need the loan for. If you’re buying a home (and you don’t have all of the cash to do it), you’ll need to get a mortgage. If you own a home and want money for another purpose, like consolidating debt or paying for home improvements, you might look into a home equity loan.