Finance

Home Equity Loan vs Second Mortgage

July 27, 2023

When you’re looking to leverage your home’s value for a loan, you’ll likely encounter the terms ‘home equity loans’ and ‘second mortgages’. Often, these two terms are used interchangeably, leading to the impression that they are, in fact, the same. Both options involve borrowing against your house using it as collateral, yet they often feature different terms and conditions. To help you get a clearer understanding, we’re going to break down these two terms and demonstrate why they’re generally considered identical.

Unpacking Home Equity Loans: Are They Second Mortgages?

A home equity loan involves borrowing against the equity you’ve built up in your home. But what is home equity? Essentially, it’s the proportion of your home you truly own, which is determined by the value of your home and the amount you’ve paid off on your existing mortgage.¹

For instance, if your home is worth $500,000 and you’ve paid $250,000 towards your mortgage, you have 50% equity. This equity value determines the maximum amount you can be approved for in a home equity loan.

Interestingly, the term ‘second mortgage‘ is used to describe a loan that uses the same property as the initial mortgage for collateral.² So, isn’t a home equity loan just another mortgage added on top of your original mortgage? Yes, it is, hence the reason it is also considered a second mortgage.

Is a Home Equity Line of Credit a Second Mortgage?

Much like home equity loans, a Home Equity Line of Credit (HELOC) is often referred to as a type of second mortgage. While both financial instruments allow you to borrow against the equity in your home, the structure of a HELOC differs from a traditional home equity loan, and understanding these differences can help you decide which might be the best fit for your needs.

A HELOC is a revolving line of credit, similar in some ways to a credit card. You’re given a maximum credit limit, and you can borrow up to that amount over a specified “draw period,” which usually lasts for about 10 years.³ During this time, you may borrow money as needed and make payments toward the balance. As you pay down the balance, your available credit goes back up, much like a credit card.

After the draw period ends, you enter the repayment period, which can last up to 15 years. During this time, you can no longer draw from the HELOC and must make regular payments until the balance is paid off.

Differences Between HELOCs and Home Equity Loans

The main differences between a home equity loan vs HELOC are the payment structure and interest rates. Home equity loans are installment loans, meaning you receive a lump sum and pay it back in regular installments over a set term. Home equity loan rates are fixed, so your monthly payments remain the same over the life of the mortgage loan.

On the other hand, a HELOC has a variable interest rate, which means the mortgage rate can change over time based on market conditions. This can affect your monthly payments, which can be a bit unpredictable. However, a HELOC offers more flexibility than a home equity loan, as you only borrow and pay interest on the money you need.⁴

So, while a HELOC is sometimes considered a second mortgage because it’s a loan that uses your home as collateral, the way it operates can be quite different from a traditional home equity loan or second mortgage. Getting a denied HELOC application can be discouraging, but it may also be an opportunity to reassess your financial habits and goals.

Understanding the Nature of Home Equity Loans and Second Mortgages

Despite the overlapping terminology, it’s worth noting that the terms of home equity loans and second mortgages can differ. Let’s look at some common factors that affect both.

Interest Rates

Interest is nearly inevitable when borrowing large sums of money, and both home equity loans and second mortgages incur interest. While these rates are ever-changing, they tend to be fixed for the term of a loan’s repayment. Currently, interest rates look like:

Home equity loans – The interest rate can vary by region and lender, but home equity loan rates currently range between 7-10%.⁵

Second mortgages – The Annual Percentage Rate (APR) of 30-year fixed mortgages have fluctuated from around 5-7% over the last year.⁶ Second mortgages, however, generally incur interest at a higher rate due to the greater risk for the mortgage lender.⁶

Loan Repayment Terms

Both home equity loans and second mortgages are long-term financial commitments, often spanning several years. Repayment terms are dependent on specific agreements and can vary widely for both types of loans:

Home equity loans – Home equity loans are repaid in monthly installments and can take anywhere from five to 30 years to fully pay off.⁷

Second mortgages – Mortgages traditionally come in 15 or 30-year terms, and payments are likewise made monthly.⁶

Tax Considerations

Both home equity loans and second mortgages allow you to make tax deductions for the interest of a loan up to $750,000 in value. They both have different guidelines dictating what the loans must be used for, however:⁸

Home equity loans – In order for a home equity loan to be tax deductible, the money must be used toward the substantial improvement of the property it was taken out against.

Second mortgages – Second mortgages may be tax deductible if the money goes towards funding a business or some other significant investment.

Benefits and Drawbacks of Home Equity Loans/Second Mortgages

There are many reasons for a home equity loan or second mortgage. They can provide a lower-cost solution compared to other borrowing methods, but they may not suffice for everyone’s financial needs. To make an informed decision, consider these pros and cons:

Pros:

Possibly lower interest rates compared to other borrowing methods.⁹
Lower risk due to borrowing against your existing equity.

Cons:

Limited borrowing amounts, usually up to 85% of your current home equity.⁷
Potential foreclosure risk if you fail to make payments.¹
Additional costs such as appraisal, document preparation, and title search fees.¹⁰
Risk of getting a denied home equity loan application

Factors to Reflect on When Considering a Home Equity Loan/Second Mortgage

Several factors can influence whether a home equity loan or second mortgage is suitable for you, including:

The amount of equity you have in your home
The sum you aim to borrow
Your capacity to repay the loan

Assessing Your Financial Status

One major consideration when taking out any loan is your ability to repay it. Any potential lenders will look at a number of factors, such as credit score and outstanding debts, before issuing either a home equity loan or second mortgage loan. Many of the minimum qualifications for either type are identical, however, including:^7,11

Home equity of around 20% or more
A credit score of 620 or higher
A debt-to-income ratio of 43% or less

Along with these figures, lenders will assess your general ability to repay your loan—a practice you should also complete before agreeing to any concrete loan terms.

Setting Your Financial Goals

Your financial goals play a significant role in determining which loan type to choose. If your objectives require a substantial sum, a home equity loan or second mortgage, which can provide up to 85% of your home’s full value, may be the answer.

Choosing a Loan Provider

If you meet the requirements for a home equity loan or second mortgage, there should be no shortage of providers ready to offer it to you. When vetting potential lenders, keep a keen eye out for:⁷

Firms that charge exorbitant upfront fees to process your loan
Companies that make unrealistic promises, like fixing your credit by paying back your debt for less than you took out
Lenders trying to charge rates outside the current APR for mortgages or range for home equity loans

It’s important to be vigilant when seeking any type of loan and carefully scrutinize the mortgage lender you plan to do business with. Loan-related fraud is a major issue in America, with nearly 200,000 cases reported in 2021 alone.¹²

Considering Sale-Leaseback Agreements: An Alternative Option

If the costs and risks of borrowing make you hesitant, consider alternative ways to get equity out of your home, like with a sale-leaseback agreement (also known as a rent-back agreement). With this arrangement, you sell your property for a lump sum and lease it back, converting your home equity to cash to use for debt consolidation, paying off student loans, navigating life events, and more, all without the need for interest payments and extended repayment terms.

Key Takeaways:

Home equity loans, often referred to as second mortgages, are based on your property’s equity.
These loans typically offer lower interest rates than other borrowing methods.
Repayment terms for home equity loans or second mortgages range from five to 30 years.
Both loan types have tax benefits, subject to specific qualifying criteria.
Important factors to consider when choosing these loan options include your home equity, desired loan amount, and repayment capability.

This article is published for educational and informational purposes only. This content is based on research and/or other relevant articles and contains trusted sources, but does not express the concerns of EasyKnock. Our goal at EasyKnock is to provide readers with up-to-date and objective resources on real estate and mortgage-related topics. Our content is written by experienced contributors in the finance and real-estate space and all articles undergo an in-depth review process.

Sources:

Consumer Financial Protection Bureau. What is a home equity loan?. https://www.consumerfinance.gov/
Consumer Financial Protection Bureau. What is a mortgage?. https://www.consumerfinance.gov/
Investopedia. Home Equity Line of Credit (HELOC) Definition. https://www.investopedia.com/home-equity-line-of-credit-heloc-definition-5217473
Investopedia. Home Equity Loan vs. HELOC: What’s the Difference?. https://www.investopedia.com/mortgage/heloc/home-equity-vs-heloc/
Forbes. Best Home Equity Loan Rates. https://www.forbes.com/
Business Insider. Current Second Home Mortgage Rates . https://www.businessinsider.com/
Forbes. What Is A Home Equity Loan?. https://www.forbes.com/
Internal Revenue Service. Publication 936 (2022), Home Mortgage Interest Deduction. https://www.irs.gov/
LendingTree. The Pros and Cons of a Home Equity Loan. https://www.lendingtree.com/home/home-equity/pros-and-cons-of-home-equity-loan/
Investopedia. Are Home Equity Loans Affordable?. https://www.investopedia.com/
Investopedia. Second Mortgage: What It Is, How It Works, Lender Requirements. https://www.investopedia.com/
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