Home equity loans and mortgages are both methods to borrow money, which involve using your house as collateral for the debt. This gives the lender the option to seize the home in the eventuality of you not keeping up with payments.
One key difference between mortgages and home equity loans is the fact that mortgages can be taken out to purchase a property, whereas to take out a home equity loan, you need to prove ownership of the property at first.
Although getting a loan has become a lot easier these days, as there are many solutions for lenders which speed up the screening and loan application procedure, it is still a confusing process, especially for first-time borrowers. Oftentimes, there is a lot of confusion regarding the two borrowing methods, with many homeowners asking what the main differences between them are, or which one is best suited for their needs. To clear the air, we are going to take a look at both options and understand the advantages, disadvantages and when each of them is best to use.
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Most people are familiar with the term “mortgage” and know it is a type of loan provided by a financial institution, which you can use to purchase a residence. Typically, lenders can provide up to 80% of the home’s estimated value or purchase price. For example, if the value of a house is situated at $100,000, the lender will provide $80,000, which means you need to come up with the remaining $20,000.
Mortgages come in many types and can either have a fixed or variable interest rate, with the borrower having to repay the amount of the loan, plus the interest rate over a fixed term, which is usually 15 or 30 years.
When you use your house as collateral, it means if you fail to make repayments, the lender can take over the home in a process called foreclosure. The house is then sold at an auction so that the lender can get their money back. In case there is another loan made against the house, such as an equity loan, the mortgage takes priority.
- Homeownership becomes more accessible: not many people afford to purchase a home with cash, whereas mortgages only require a down payment, which is usually around 20% of the home value.
- Interest rates tend to be lower than other types of loans: because you will be using the house as collateral, the lender is covered in case something happens and you can’t make payments. Because of this, interest rates tend to be much lower when compared to other loans.
- It can improve your credit rating: a mortgage loan that is always paid on time will improve your credit rate, making it easier to qualify for other loan products in the future.
- It helps you grow your wealth: compared to rents, where each month you pay a small investment to someone else’s asset, the mortgage will help you invest in your own home.
- You need to meet unique eligibility criteria: to qualify for a loan, you need to meet some strict standards, including having a good credit score, making a down payment and showing a good debt-to-income ratio.
- You end up paying a lot more money in the end: unfortunately, just as with any type of loan, by the end of your mortgage payment, you will end up paying a lot more than the actual value of your house.
- You could risk foreclosure: if you end up not being able to repay the lender, they can sell your house at an auction, so that they can recoup their money.
- You need to factor in other expenses as well: besides the down payment and monthly repayments, you may also have to pay for other costs, such as fees, appraisal costs or mortgage insurance.
Home Equity Loans
A home equity loan can also be perceived as a mortgage, although there are some significant differences between the two. The main difference is that you can’t take a home equity loan if you haven’t already accumulated equity in a property. In contrast, you take out a mortgage so that you can accumulate equity in it.
This is a type of secured loans, meaning you will use your equity to guarantee the repayment. If you already have a mortgage, your equity will be represented by the difference between the home value and the existing mortgage balance. For example, if you took out a mortgage for $200,000, but you still owe $150,000, then you end up with $50,000 in equity, which is the amount you can borrow against.
Just as mortgages, home equity loans are repaid over a fixed term. The lender will take into consideration your credit score, loan-to-value ratio and owned equity to determine the amount of money they can lend you.
Because many properties are purchased with mortgages, a home equity loan is often considered a second mortgage. This means if the home goes into foreclosure, the home equity loan lender will be exposed to higher risks, as they have to wait for the mortgage lender to be repaid first. This is why home equity loans usually carry a higher interest rate than mortgages.
- Lower, fixed interest rates: home equity loans are suited if you need money fast, and because you will be using an asset as collateral, interest rates are usually lower than personal loans.
- Home equity loans may be tax deductible: this means it can be removed from your taxable income, lowering your tax expense liability.
- It gives you fast access to a significant sum of money: if you have enough equity in your home, you can borrow a fair amount of money to use as you please.
If you sell the house, you need to pay back the loan immediately: because you don’t have collateral to guarantee with anymore, the loan needs to be paid in full.
Foreclosure: just as with mortgages, if you fail to repay the lender, they can sell your house to recover their money.
Both mortgage and home equity loans have their own set of pros and cons and are better suited for specific situations. Ultimately, it is up to you to choose a type of loan that suits your needs and does not jeopardize your financial security.