What’s the difference between home equity loans vs. mortgage loans? While they are both loans that require a similar process to obtain and use your home as collateral, they do not serve the same purpose.
As a homeowner, you might find yourself in need of a home equity loan, but you often can’t become a homeowner without a mortgage unless you pay in cash.
Keep reading to learn about the difference between these two loan products, what makes them good and bad in different situations, and how to decide between the two.
Home Equity Loan vs. Mortgage Loan Similarities
While they don’t serve the same purpose, a home equity loan and a mortgage do have some similarities.
One is the process of getting these loans. When you’re approved for a mortgage and a home equity loan, you have to go through the closing process. This is unlike other loans, such a car loan, student loan, or personal loan. The closing process requires that you have a real estate attorney or a settlement company. You have to prove that you’ve met all the conditions of the loan, pay closing costs, etc.
Also, for a home equity loan and a mortgage loan, you use your home as collateral. That means if you fail to make your mortgage payments or your home equity loan payments as agreed upon, your home can go into foreclosure.
Finally, both loans allow you to make fixed payments over a set term with a fixed-rate loan. This is unlike a credit card or home equity line of credit in which the amount you pay varies over time based on how much you borrow and the interest rate.
What’s Different With Home Equity Loans vs. Mortgage Loans?
The primary difference between a home equity loan and a mortgage is the purpose.
A mortgage is for you to purchase a property. When you decide that you want to buy a home, you borrow money to buy a house in the form of a mortgage.
On the other hand, a home equity loan can be taken out once you’ve already purchased a home. To acquire a home equity loan, you must have equity in your home. Equity is the difference between the market value of your home and the principal balance of your mortgage.
For example, if your home’s value is $400,000, and your mortgage balance is $100,000, your home has $300,000 in equity. You can take out a loan against the $300,000 in equity.
Another difference is the tax advantage of each. The interest you pay on your mortgage is tax-deductible. That means it will lower your tax liability by decreasing your taxable income. The interest you pay on a home equity loan is only tax-deductible in certain circumstances.
Tax law states that the interest on a home equity loan that’s used to build an addition to your property is deductible. However, if you use it for reasons such as paying off credit card debt or financing a wedding, it isn’t.
Pros & Cons Of A Mortgage
Securing a mortgage is the primary route to homeownership for many unless you have a large sum of cash available through savings or inheritance.
Aside from a mortgage making homeownership possible for many, you can secure a low fixed rate to keep your payments affordable. Mortgage rates are at historic lows, and it’s the best time to take advantage of purchasing a home.
There are also disadvantages to getting a mortgage. If you fail to make your payments regularly, your lender can foreclose on your home, which will have a severely negative impact on your credit. Also, if the value of your home decreases, you might find yourself owing more than your home is worth, which is also known as being upside down on your mortgage.
It’s an excellent time to take out a mortgage if you’re financially prepared for homeownership with your emergency savings in place, a stable income, and if you’re prepared to stay in your home for an extended period.
However, if you suspect that you might be changing jobs, if your income is uncertain, if you plan to quit your job or start your own business, if you’re considering moving to another city, etc. you should put a hold on taking out a mortgage.
Pros & Cons Of A Home Equity Loan
A home equity loan allows you to borrow a lump sum of money to take care of various financial needs. Since the loan is secured with your home as collateral, it allows you to qualify for lower interest rates than if you were to get an unsecured personal loan or unsecured credit card.
While the average interest rate for a home equity loan is in the single digits, both personal loan and credit card interest rates often creep into double-digit numbers, which can cost you thousands in extra payments over your loan’s term.
As with a mortgage, you will find disadvantages to getting a home equity loan as well. Many are similar.
One is that your home can also be foreclosed on if you fail to make your payments. Keep in mind that even if you make your primary mortgage payments on time, failing to make your home equity loan payments can also lead to a foreclosure. This would be a severe consequence, especially if you used the money for more frivolous reasons such as a vacation.
If the value of your home decreases, you might find yourself owing more than your home is worth. Also, when you borrow against the equity in your home, you will collect less profit when it’s time to sell it.
A home equity loan is a reliable option for you if you can easily afford the additional loan payment, if you’re making improvements to your home that significantly increase the value, or if you’re saving money by replacing your high-interest debt with a low-interest home equity loan.
You should reconsider if you don’t have consistent income, if you anticipate selling your home soon or if your property value is decreasing since you could eventually owe more between your mortgage and home equity loan than the property is worth.
How To Decide Between Home Equity Loans vs. Mortgage Loans
Deciding which type of loan you need is relatively simple. When you’re purchasing a home, only a mortgage will provide you with proper financing. If you already have a mortgage with equity, a home equity loan is your option.
These are both major financial responsibilities and ones that should not be entered into lightly. Be sure to take the time to research the options, determine which is best for you, and find a lender that will help you get the financing you need.