A home equity loan is basically a loan that provides borrowers with an opportunity to borrow a specific sum of money secured against their home. It is calculated as the current market value of the home minus the balance owed on the mortgage. Thus, if the value of your home is 200 000 dollars, but you still owe 150 000 dollars to your mortgage company, you have equity of 50 000 dollars.
This equity is used as security when obtaining a cash home equity loan. It is similar to mortgage or auto financing – you borrow money from the lender and repay it gradually with interest. However, unlike in the normal mortgage, you often do not use a home equity loan to financing acquisition of the property. However, it is often utilized for large purchases such as home renovation, medical expenses, fees for college, or to payoff credit card debts that have high interest rates.
So what is the twist in a home equity loan compared to a second mortgage? It is possible to make some comparisons between them, but they also have certain differences.
Purpose The primary distinction between a home equity loan and a second mortgage can be summed up in the word ‘use’. A home equity loan is a type of credit that you can borrow against and use as you wish, much like a credit card. Interest costs are calculated only on the principal amount borrowed, not on the total amount for which the credit is line. That is, it operates in a manner that resembles a credit card account than an actual mortgage.
On the other hand, second mortgage is taken for a specific sum of money for a specific purpose such as acquiring another home or making another purchase. The interest rate and the payment schedule do not change and are locked in for the entire duration of the loan period.
Interest Rates In most cases, home equity loans are known to attract lower interest rates than those that come with second mortgage. This is so because your home is used as security for a home equity loan therefore the risk of lending to you is relatively low for the lender. The interest rates of second mortgages are generally higher because this is a second position which is repaid after the first mortgage.
Payback Terms Second mortgages also have regular and equal monthly payments like your primary mortgage, and a definite payment period. HELOCs are credit facilities that are revolving and may not involve, payment of the principal amount while in the draw period. This flexibility makes one to borrow without having to take a number of loans at the same time.
Closing Costs For home equity loans, closing costs are also relatively low in comparison to other types of loans. Since it is a home equity loan, there is no property purchase which entails charges such as title search fees, appraisal fees, inspection and survey fees. The application process is relatively simple to maintain closing costs as low as possible.
Impact on Home Ownership Nevertheless, it is crucial to note that with a home equity loan, you do not lose your ownership rights the way you would with a second mortgage. You continue to own your home, but the title is held by the lender until the loan is paid off. However, the second mortgage holder can come and repossess your home if you fail to make your payments as agreed like the first mortgage holder.
Tax Implications The interest paid on a home equity loan is also tax-deductible up to specific limitations provided that the borrowed amount is to be used for a material and substantial renovation of the home. Interest on second mortgage is allowed only where the amount is used to purchase, build or renovate your residence. Refinancing debts or taking cash out does not qualify for deductions.
When to Use Each
Here are the best uses for each type of financing:Here are the best uses for each type of financing:
Home Equity Loan:
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Pay off higher rate/interest and non-deductible balances
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The following are some of the most common home improvements among finance major homeowners:
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Cover emergency medical costs
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Pay college tuition
Second Mortgage:
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Save for a deposit on a holiday home or a rental property
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Purchase a second home or more specifically a condo.
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Construct an addition to your house
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Finance a large home improvement
While taking any loan, ensure that you agree to certain conditions and ensure that you understand all the charges and the terms of the loan, the risks that come with the loan, and the tax implications of the loan. However, a home equity line of credit is still cheaper in terms of rates and costs than a second mortgage or cash-out refinance. It gives you a flexible way of accessing your equity without contracting several loans. But make sure that your housing market and your source of income are stable before using home as security to borrow money.
