Home equity loan vs. mortgage: What's the difference?

When you’re looking to buy a home, especially your very first one, you may find the loan terminology confusing. This is especially true when learning about different loan types, like home equity loans and mortgages.

Home equity loans and mortgages are not the same. Simply put, a mortgage is used to finance the purchase of a home. A home equity loan is typically used when a homeowner wants to borrow against the equity they’ve built up in their home. Let’s break down the details of these two financing options and how they work.

What is a mortgage?

A mortgage is the most common way to finance the purchase of a house. It’s a loan that is repaid with interest over a period of many years, typically 15 – 30. Most of us can’t afford to purchase a $400,000 home upfront with cash – so a mortgage makes it possible for us to split the cost into manageable monthly payments over a long period of time.

It’s important to note that we’re talking specifically about primary mortgages here. Home equity loans are technically second mortgages, which function differently.

How mortgages work

When you get a mortgage to purchase a home, you make an agreement with a lender that you will repay the cost of purchasing the home over a specified period of time, plus interest. When your loan closes, you will own and be able to live in the home as you slowly repay the cost to purchase it. You will also build equity in your home as you make payments.

Until the loan is completely repaid, your lender retains a mortgage lien on the property. That means that if you fail to make payments toward your loan, your lender may be able to take back your house and sell it to someone else to recoup their losses.

Once you completely pay off your mortgage balance, the home will be yours outright. No more payments required, until you choose to sell it. You can also sell a home before your mortgage is paid off, as long as you can sell it for enough to pay off the remaining balance of your loan.

What is a home equity loan?

Home equity loans are second mortgages that can allow you to borrow more money for things like home improvements, debt consolidation and more on top of the money you’re already borrowing to pay for your house. They can be taken out without impacting the terms of your original mortgage. It’s also possible to take out a home equity loan after you’ve fully repaid your primary mortgage.

Home equity loans use the money you’ve already invested (or earned) in your home, known as equity, as collateral for the loan. If you fail to repay a home equity loan, much like defaulting on a mortgage, you could risk foreclosure.

How home equity loans work

You can get a home equity loan for as much as 80% – 85% of your home’s value, typically, though some lenders may allow you to borrow more in certain circumstances. To find out how much you could potentially borrow for this type of second mortgage, you would calculate the percentage of your home’s value that you are allowed to take out by your lender and then subtract what you still owe on your mortgage.

So, if your home was worth $350,000 and you can borrow up to 85%, that would be $297,500. Let’s say you still owe $200,000 on your mortgage. $297,500 - $200,000 = $97,500. In this case, you’d likely be able to borrow $97,500 for home improvements, repairs or any other purpose you see fit.

The amount you borrow with a home equity loan gets disbursed to you as a lump sum. You then pay off the amount you borrowed, with interest, alongside your mortgage for a set number of years. Because your home acts as collateral for the loan, your lender may be able to foreclose on your home and resell it to recoup losses if you default. So, it’s important to be sure you can afford to repay a home equity loan before taking one on.

Home equity loan vs. home equity line of credit

Another method of using your home equity to obtain extra funds is to take out a home equity line of credit, or HELOC. A HELOC uses your home equity as collateral, just like a home equity loan.

Unlike a home equity loan, however, a HELOC works like a credit card. You can borrow any amount of money up to a limit based on the equity in your home. You’ll pay interest on whatever you’ve borrowed during a phase called the draw period. Once that phase ends, you’ll repay the line of credit based on the principal balance and remaining interest.

A HELOC uses your equity as collateral, just like a home equity loan. So as with the other loan type, be sure you can afford the payments before borrowing money this way. A failure to stay current on your payments could ultimately result in you losing your home. Rocket Mortgage© doesn’t offer HELOCs at this time.

Key differences between mortgages and home equity loans

We’ve included this table to help summarize the key differences between these two loan types.

Which loan is the best option to use?

There is no best loan option above all others – the loan that’s best for you will vary based on your unique financial situation and circumstances. Depending on what you’re financing, let’s discuss whether a home equity loan or mortgage would make more sense for you.

When to use a home equity loan

If you already have a mortgage or have paid one off in full but want some cash to pay for a major purchase, renovation or debt consolidation, a home equity loan may be a great choice for you. Though you will have to take on a second payment, these loans can help you afford big expenses that you may not have been able to finance otherwise.

When to use a mortgage loan

If you want to purchase a home or an investment property, a mortgage is probably the right loan choice for you unless you can afford to purchase a property with cash. There are many mortgage options out there, some fixed-rate and others adjustable. To learn more about what mortgage options may be available to you, talk to a mortgage lender like Rocket Mortgage.

FAQs about home equity loans and mortgages

Below are some of the most common questions that come up when discussing these loans.

Is it cheaper to get a home equity loan or a mortgage?

It depends on the loan value and terms. Closing costs on a second mortgage are generally less than closing costs on a primary mortgage, so home equity loans may be cheaper initially. However, primary mortgages usually have lower interest rates than second mortgages like home equity loans.

Is a home equity loan different from refinancing a mortgage?

Yes, they’re different. A home equity loan is a second mortgage, meaning it's an additional home loan that doesn’t affect the terms of your original mortgage. You’ll owe payments on both loans.

When you refinance a mortgage, you replace the terms of the original loan with the terms of the new refinanced mortgage. With a refinanced mortgage, you still only have one payment to make.

Can I buy property with a home equity loan?

Yes, you can use the funds from a home equity loan to buy another home. For example, you might use the funds to cover your down payment. Or, if the property is affordable enough and the loan is big enough, you could potentially finance the entire purchase with a home equity loan.

Can I deduct taxes on home equity loans and mortgages?

If you take the standard deduction, no you cannot. If you itemize deductions, yes, it’s possible to make deductions for both types of loans.

The bottom line

If you’re looking to purchase a home, a mortgage is likely the type of financing you will want to pursue. If you already have a home and are searching for ways to use some of your equity for a large purchase, a home equity loan can be a great option. Knowing the difference between these two loans, as well as others, will help you make informed decisions as you explore different financing options throughout your homeownership journey.

Ready to purchase a home or see your loan options? Start your approval online with Rocket Mortgage today.