Home Equity Loan Vs. Mortgage: 6 Key Differences

Once you’ve built up enough equity in your home, you might feel ready to take advantage of that equity in the form of a home equity loan (also called a second mortgage). However, a home equity loan is quite different from a traditional mortgage in several ways.

In this article, we’ll explore how a home equity loan compares to a first-lien mortgage by examining six key differences between these two popular financing options.

What Is A Mortgage?

Before we dive into what a home equity loan is, let’s go over some mortgage basics. Since a home is such a large purchase, a mortgage allows you to purchase it and then pay off your home with interest in monthly installments over the length of a specified term, usually 15 or 30 years.

Entering a mortgage agreement means you’re responsible for repaying the cost of your home to your lender. While you do own the home, your lender is able to reclaim your house if you fail to make your loan payments.

However, once you pay off your mortgage completely, you no longer need to make payments and you own your property outright. If you choose to sell your home before paying off your mortgage, you’ll need to be able to pay the remaining balance of your loan with proceeds from the sale.

Requirements To Get A Mortgage

Before approving you for a mortgage, your lender wants to make sure that you’re in a good financial position to comfortably afford the significant costs of homeownership.

Here are some general requirements you’ll likely be expected to meet. Keep in mind that that requirements will vary based on your mortgage type and lender.

• Credit score: You’ll usually need a credit score of at least 620 to qualify for a conventional loan (or mortgage). However, some government-backed mortgages like FHA loans and VA loans allow you to get a mortgage with a lower score.
• Debt-to-income ratio (DTI):Your DTI reveals how much of your monthly income is consumed by your monthly debt. Lenders look for a DTI of lower than 50% when considering borrowers for a mortgage. The lower your DTI, the better.
• Income: While there’s no specific income requirement for a mortgage, you’ll need to have enough monthly income to cover your mortgage payments and other expenses. Lenders look for consistent income from not only your salary, but also other sources like side gigs or investment accounts.
• Assets: If you fall on hard times financially, having assets can ensure that you’ll still be able to make your mortgage payments. Lenders will evaluate if you have assets in the form of checking and savings accounts, stocks, bonds, certificates of deposit (CDs) and more.
• Property type: A primary residence is the easiest type of property to secure a mortgage for. Keep in mind that if you’re trying to get a mortgage for another type of property, such as a second home or investment property, you’ll need a higher credit score, DTI, and down payment.

What Is A Home Equity Loan?

To understand what a home equity loan is, you need to know what home equity is first. Your home equity is the difference between how much you owe on your mortgage and what your home is worth.

A home equity loan is a type of second mortgage given to you in a lump sum. With the equity you’ve acquired, you can borrow money to fund major purchases and consolidate your debt. You’ll then pay off your home equity loan in conjunction with your mortgage for a specified period of time.

Say, for example, your home is worth $300,000. You’ve paid down your loan balance and now only owe $200,000, which gives you $100,000 in home equity. Since homeowners can usually borrow up to 80%-85% of home equity, this means you may be able borrow up to $40,000.

Keep in mind, though, that getting a home equity loan means taking on more debt. So, make sure you have a solid and realistic financial plan before going this route. 

Requirements To Get A Second Mortgage

Since a home equity loan is a type of second mortgage, you’ll also need to meet certain qualifications to be approved for one. Your lender will examine the following:

• Home equity: You’ll usually need at least 15 - 20% of equity in your home to qualify for a home equity loan.
• Loan-to-value ratio (LTV): Your loan-to-ratio value is expressed in a percentage and can help you figure out how much home equity you could receive. Lenders look for at least an 80 - 85% LTV, but the lower the better. A lower LTV means you have more equity in your home.
• Credit score: The higher your credit score, the more equity you’re usually able to access. Most lenders require a credit score of at least 680. However, even with a lower score, you may still be able to get a home equity loan if you have sufficient equity in your home and a low DTI.
• Debt-to-income ratio (DTI): To qualify for a home equity loan, you’ll usually need to have a DTI of 50% or lower. A high DTI signals to lenders that you may not be in a position to take on more debt.

6 Differences Between Home Equity Loans And Mortgages

Let’s now consider six key differences between home equity loans and mortgages. By learning more about their differences, you can make the most informed decisions about which financing option is right for you.

1. The Purpose Of The Loan

A first mortgage and a home equity loan serve different purposes. A mortgage grants you ownership of a home without having to pay for it upfront. Instead, using your home as collateral, you pay back your lender in fixed installments over a period of time.

A home equity loan is a second mortgage that allows you to borrow a lump sum based on the equity you’ve built in your home. You can then use the funds any way you see fit. Some borrowers use them for major home improvements or for other personal reasons.

2. Interest Rates

Interest rates for home equity loans are typically slightly higher than the interest rates for mortgages. However, home equity loans can also come with lower fees, so it may still be ideal for you. Before settling on a home equity loan, make sure it’s the right choice for your financial situation and goals. 

3. Fixed Interest Rates Vs. Adjustable Interest Rates

Most home equity loans offer a fixed interest rate, meaning it doesn’t change during the life of the loan. Rather, you’ll pay the same amount each month until the loan is paid off.

Mortgages, on the other hand, can have fixed or variable interest rates. An adjustable-rate mortgage (ARM) typically offers lower introductory rates compared to a fixed-rate mortgage during the initial fixed period of the ARM. Once the introductory period is over, however, the interest rate will reflect the current market rate. 

4. Closing Costs

You’ll typically pay 2%-6% of your total loan amount in closing costs for both mortgages and home equity loans. It is possible, however, to reduce your closing costs by exploring different lender options and negotiating.

For home equity loans, some lenders may be able to waive some of your closing fees in exchange for a higher interest rate or as a lender credit. This could be worthwhile if you plan on paying off the loan rather quickly.

5. Lien Priority

Lien priority refers to the order that creditors get paid if a foreclosure happens. Your first mortgage has lien priority over a home equity loan, which, as mentioned, is considered a second mortgage.

In the unfortunate event that your home is foreclosed, your first-lien mortgage gets reimbursed from the foreclosure proceeds. Then, your second mortgage is paid with the remainder. This is why lenders can view a home equity loan as riskier.

6. Tax Deductions

According to the Internal Revenue Service (IRS), you’re able to deduct home mortgage interest on up to $750,000, the specific amount varying by filing status. 

For home equity loans, the IRS reports that a tax deduction is allowed only if you use the funds for home improvements. Using your home equity loan for other purposes, like living expenses or personal debt, does not qualify for a tax deduction.

Keep in mind that this rule applies for the 2018-2025 tax years. For tax years outside of this time frame, you may be able to use your home equity loan for non-home expenses and still deduct the interest paid.  

HELOC Vs. Home Equity Loan

Very similar to a home equity loan, a home equity line of credit (HELOC) lets you use the equity in your home to pay for anything you choose. The difference, however, is that a home equity loan is a lump sum loan with a fixed interest rate. A HELOC, on the other hand, has a revolving line of credit and an adjustable rate.

Common features of a home equity loan include:

• Gives borrower a single lump sum payment
• Has a fixed interest rate
• Usually allows borrower to access up to 80%-85% of home equity
• Unable to withdraw more money

Common features of a HELOC include:

• Gives borrower access to a revolving line of credit for a set period of time
• Has variable interest rate and minimum credits based on borrower’s financial situation and market conditions
• Borrower can withdraw as little or as much as they need
• Borrower is able to draw credit for emergencies

The Bottom Line: You Need A Mortgage To Get A Home Equity Loan

A home equity loan is a type of second mortgage you can take on using equity from your home, allowing you to fund other home-related or personal expenses. You’ll need to have an existing loan or recently paid one off to get a home equity loan.

A home equity loan can be a powerful tool, but it also comes with a great deal of financial risk and responsibility. Before getting a home equity loan, make sure your finances are in good shape. Download the Rocket Money℠ app to track your spending and start saving to pay off your future home equity loan.