Home equity loan vs. mortgage: What’s the difference?
Key takeaways
- Both mortgages and home equity loans are secured by property. A mortgage is used to purchase the property, while a home equity loan taps the value of that property for various expenses.
- Compared to other forms of credit, both a mortgage and a home equity loan tend to offer lower interest rates and larger loan amounts.
- Home equity loans almost always have a fixed interest rate, while a mortgage can have a fixed or adjustable rate.
- A mortgage is in the first lien position on the property so that the lender recoups its losses first in the event of foreclosure. A home equity loan is in the second position, making it riskier for lenders.
Home equity loans vs. mortgages: Similarities and differences
Apples and oranges, while different, are still both fruits. In much the same way, mortgages and home equity loans are two types of loans having to do with your home. But their similarity stops there. In general, mortgages are used to purchase a home, whereas a home equity loan allows you to borrow against the fair market value of your home, receiving ready cash for it.
A summary: Home equity loans vs. mortgages
| Mortgage | Home equity loan | |
|---|---|---|
| Purpose | To purchase a home | To receive cash using your home’s equity |
| Collateral | Yes, the property | Yes, the property |
| Interest rates | Lower than home equity, either fixed or adjustable | Higher than a mortgage but lower than a personal loan or credit card, usually fixed |
| Lien position | First | Second |
| Closing | Longer closing time and higher fees than a home equity loan | Shorter closing time and fewer fees than a mortgage |
Let’s break down the similarities and differences further.
Similarities between mortgages and home equity loans
- Secured by property: With both home equity loans and mortgages, your home is used as collateral for the loan. That means if you don’t repay the debt, the lender can foreclose on the property.
- Borrow a relatively large amount: Mortgages and home equity loans allow you to borrow well into the six figures or even higher, unlike most personal loans.
- Lower interest rates: Compared to personal loans or credit cards, mortgages and home equity loans have much lower interest rates. That’s because they’re backed by your property, lowering the risk for lenders.
- Similar qualifying criteria: Mortgages and home equity loans require certain financial qualifications to get a loan, relating to your credit score, loan-to-value (LTV) ratio and debt-to-income (DTI) ratio.
Differences between mortgages and home equity loans
- Lien position: The primary mortgage always occupies the first lien position on a home. 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. Next in line would be the lender of the home equity loan and so on.
- Closing: Home equity loans typically close faster and come with fewer closing costs than mortgages.
- Risk and interest rates: Since a primary mortgage takes a first lien position, it’s less risky to lenders than a home equity loan. This translates to rates on home equity loans being typically higher than purchase mortgage rates.
- Qualifying: While mortgages and home equity loans share types of qualifying criteria, it’s typically harder to qualify for a home equity loan. In general, home equity loans require you to have more than 20 percent equity and a credit score in the mid-600s. On the other hand, an FHA loan can be had with 3.5 percent down and a credit score as low as 580.
- Fixed or adjustable rates: Mortgages can come with a fixed or adjustable rate, while home equity loans typically have fixed rates.
How does a mortgage work?
A mortgage is a loan that helps you finance a home purchase. 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. You can get one after you’ve paid off your mortgage or while you’re still repaying it. A home equity loan allows you to borrow against the ownership stake you’ve built up in the home (basically, the home’s value minus your mortgage balance). You can use the money for any purpose. Common choices are home renovations/repairs and consolidating debt.
Let’s say your home is worth $400,000, and you owe $150,000 on your first mortgage. That means you have $250,000 of equity in your home, and you can use that equity as the collateral for a loan. You’re required to keep 20 percent of your home’s appraised value untouched. So, in this scenario, you’d be required to keep $80,000 in equity, leaving you with up to $170,000 to borrow.
Applying for a home equity loan is similar to applying for a mortgage; a home equity loan is also known as a second mortgage. “The process is generally the same between a mortgage and a home equity loan in that the lender has to evaluate income and employment and appraise the property,” says Vikram Gupta, head of home equity for PNC Bank.
To qualify for a home equity loan, you’ll generally need at least 20 percent equity, a credit score in the mid-600s and an acceptable debt-to-income (DTI) ratio. However, “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.
A HELOC — or home equity line of credit — is another option that lets you tap your equity. Instead of getting a lump sum, as you would with a home equity loan, HELOCs allow you to withdraw money as you need it, similar to using a credit card. Typically, HELOCs have variable interest rates and come with a draw period during which you can borrow funds, followed by a repayment period.
Which loan type is best for you?
The answer depends on what you need the loan for. Ask yourself these questions:
- Do you need to finance a home purchase? If yes, then chances are you need a mortgage.
- Do you already own a home and need money for a large expense or debt consolidation? Then you could consider a home equity loan.
Bottom line
Mortgages and home equity loans both use the home and property as collateral and offer lower interest rates than personal loans and credit cards. A mortgage is used if you’re purchasing a new home and takes the first lien position. A home equity loan may be used if you already own a home and the home has equity you’d like to utilize; it takes the second lien position.
FAQ
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