Home Equity Loan Vs. Mortgage: What’s The Difference?
Sidney Richardson6-minute read
February 20, 2023
When you’re looking to buy a home, especially your very first one, all the loan terminology you’re being introduced to can feel confusing. You probably want to make sure that you find the right financing option to pay for a house, but you may not be sure exactly what that is.
If you’ve heard the term “home equity loan” floating around recently, you’re likely wondering what this popular loan option is and whether it would work for you. Today, let’s break down the details of exactly what this type of financing is and how it differs from a regular mortgage loan.
What Is A Mortgage?
Before we discuss home equity loans, let’s talk about what a mortgage is. 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.
How Mortgages Work
When you get a mortgage, you make an agreement with a lender that you will repay the cost of purchasing a 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. All the while, however, your lender retains some “rights” to the home, so to speak. 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.
If you manage to completely pay off your mortgage balance, on the other hand, the home will be yours, 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.
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What Is A Home Equity Loan?
A home equity loan is another form of financing, but it differs from a mortgage in many ways. This type of loan is one you get while you already have a mortgage – or perhaps after you’ve paid a mortgage off. 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. You cannot use a home equity loan to purchase the entirety of a house the way you do with a 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.
This amount is given to you as a lump sum. You will pay off the amount that you borrowed with interest alongside your mortgage for a set number of years. If you default, since your equity is used as collateral, your lender may be able to foreclose on your home and resell it to recoup losses – so it’s important to be sure you can afford this extra payment before taking it on.
The Differences Between Mortgage Refinances, Home Equity Loans And HELOCs
Now that you know the difference between mortgages and home equity loans, let’s go a little deeper. Like a home equity loan, ther e are also other methods of obtaining additional financing for repairs, improvements and debt consolidation when you already have a mortgage to repay. Let’s learn what refinancing is, what home equity lines of credit (HELOCs) are and how these other methods of obtaining additional cash or altering your loan can affect you.
Home Equity Loan Vs. Refinance Mortgage
If you’ve heard that you can obtain money to fund projects or consolidate debt by refinancing your mortgage, you heard correctly. But before we can talk about how to do that, let’s go over what a refinance actually is.
When you refinance your mortgage, you replace your old loan with a brand new one. Your new loan will likely have a different principal balance and interest rate. People refinance their loans for many reasons, including to get a lower interest rate when rates drop, to remove a name from the house title and, of course, to cash out equity in the mortgage.
A cash-out refinance is a special type of refinance that allows a borrower to not only refinance, but also withdraw some of the equity they built in their home for personal use. Borrowers can withdraw a portion of the difference between their home’s value and what they owe on the mortgage. The amount they withdraw is then added to the new loan amount.
With a cash-out refi, you get a lump sum of your equity to use as you please at the cost of a new mortgage with a higher principal balance. This method differs from a home equity loan because it does not involve a second mortgage payment – it simply transforms your old mortgage loan into a new one.
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 will pay interest on whatever you’ve borrowed during a phase called the draw period, and then once that phase ends you will 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 just like 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.
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 other adjustable. To learn more about what mortgage options may be available to you, talk to a mortgage lender like Rocket Mortgage.
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 utilize 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.
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