What’s the difference between a mortgage and a home equity loan?
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Take a look at any bank’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 a mortgage, that stake in the property becomes your equity, and it allows you to borrow more through a home equity loan.
How a mortgage works
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
- 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 a home equity loan works
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,” notes Vikram Gupta, head of home equity for PNC Bank.
Mortgage vs. home equity loan
With both a mortgage and a home equity loan, you’re borrowing money and committing to repaying it. If you break that promise, the lender can take your home, since it’s the collateral for both of these types of loans.
Because both loans can involve a hefty sum of cash, the application 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,” Gupta says.
During at least one stage, though, the home equity loan process is faster, Gupta points out.
“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,” Gupta says.
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 three years,” Gupta says.
However, while you’ll save money on the closing costs, rates on home equity loans are typically higher than mortgage rates. That’s because a home equity loan is typically the second mortgage, and the lender of the first mortgage is first in line to recoup money if your home were to go into foreclosure.
What is a second mortgage?
A home equity loan is one example of a second mortgage. You might be wondering why someone would want a second load of debt to pay back. Mortgage rates tend to be much lower than other products like credit cards or personal loans because you’re putting your home on the line to borrow the money, so they’re a less expensive type of loan overall.
Some borrowers use second mortgages to pay for renovations on their homes or other major expenses like college tuition.
What about cash-out refinancing?
If you need access to cash but don’t want to add a second mortgage to your bottom line, cash-out refinancing can be the solution. Instead of another loan, this option pays off your existing mortgage by refinancing into a bigger loan. A cash-out refinance is especially wise if you can lock in a lower rate than the one you got initially.
When you need to borrow money, your home can serve as the collateral to access the cash. However, remember what you’re putting on the line: If you fail to make payments on a mortgage or a home equity loan, the lender has the right to take ownership of your home.