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Which is Better – a Home Equity Loan or a Second Mortgage?

Which is Better – a Home Equity Loan or a Second Mortgage?

Home Mortgages
SouthEast Bank| March 3, 2023
Which is Better – a Home Equity Loan or a Second Mortgage?

Which is Better – a Home Equity Loan or a Second Mortgage?

Houses typically serve two purposes for those who buy them; one is to live in them and create a home, while the other is to help build wealth through equity in the house. To access that equity, though, you have to wait until you can sell the entire house and then use the profits for cash, or you can opt to take out a second mortgage.

Second mortgages are popular options for homeowners looking for extra money to pay bills or reach their financial goals. But when looking up how to get a second mortgage, you might come across the term home equity loan. What is an equity loan, and what is different about a home equity loan vs a second mortgage?

What is a Second Mortgage?

Second mortgages are just that – another mortgage that is taken out after a home is purchased that gives a homeowner access to the equity that has been built into the house. It is a lien that is taken out against a property that already has a mortgage on it. 

The second mortgage’s lien is taken against the portion of the home that you have already paid off. If you have just begun paying on your loan, a second mortgage won’t be the best option for you as you won’t have any equity built into the house yet. Instead, if you are short on cash, you may consider a personal loan

Money from the second mortgage can be used for almost anything, such as paying off credit card debt, paying for a wedding, or remodeling your current home. 

What is a Home Equity Loan? 

In short, there is no difference between a home equity loan vs a second mortgage; a home equity loan is a second mortgage. The term second mortgage refers to the two types of second mortgages available: home equity loans and home equity lines of credit, or HELOCs. 

Home equity loans are a type of second mortgage that allows you to borrow money against the equity that’s built up in your house. To qualify for a home equity loan, many lenders will require at least 20% of the equity in your home as well as good credit scores and a low debt-to-income ratio. 

Most borrowers will only let you borrow up to about 80% of your home’s total equity. If your home has been recently valued at $400,000 and you have a balance of $150,000 left on your mortgage, you have $250,000 worth of equity. If you are approved for 80% of that equity, your second mortgage would be around $200,000, which you can use to meet your financial goals.  

As with your first mortgage, you will still have to make payments on the second mortgage. Many home equity loans have fixed interest rates and fixed payment terms between 5 and 30 years. When deciding if a second mortgage is right for you, calculate interest to ensure you understand exactly what you will be paying. 

HELOC vs Home Equity Loan

The other type of a second mortgage is a home equity line of credit or a HELOC. Like a home equity loan, a home equity line of credit allows you to borrow against the equity in your home and use it for almost anything. 

A HELOC, though, lets you borrow what you need only when you need it. It also only charges interest on the amount you borrow rather than the lump sum, similar to how a credit card works. A home equity loan requires you to pay interest on the principal. 

Once you have borrowed the needed amount, you will have regular monthly payments until the HELOC is paid off. The other difference between a HELOC and a home equity loan is that the home equity line of credit usually comes with variable interest rates, which are rates that change depending on market conditions. If interest rates go up, so will your monthly payments, regardless of what you have spent. 

Which is better for you – HELOC or a Home Equity Loan?

If you are looking to tap into your home’s equity through a second mortgage, a home equity line of credit and a home equity loan are good options. However, deciding which one is right for you will depend on a few factors, such as the equity available, what you’ll use the money for, and alternatives to second mortgages. 

Home equity loans are best for people who have a good idea of what they are using the loan for and how much of it will be used. These loans allow for more predictability with the same monthly payment over the lifespan of the loan. 

On the other hand, HELOCs are more flexible if you’re not sure how much money you will need for a project. They allow you to borrow only as much as you need, and interest will only be charged on what you spend instead of having to pay interest on a lump sum that you may or may not spend all of.

When to Take Out a Second Mortgage

Taking out a second mortgage, whether it is a HELOC or a home equity loan, is a big financial decision and should be thought over carefully. A second mortgage may sound appealing to finish that basement remodel you’ve been working on but remember, it also means an additional monthly payment which could strain your finances if you aren’t ready for it.

Second, mortgages can be useful for:

Home improvements – Over time, living in your house can cause a lot of wear and tear. Bathrooms get dated, and carpets need to be replaced. A second mortgage can be a good option to access extra money that you can put back into your home. Interest on second mortgages can also be tax-deductible in some cases when used for home improvements.

Buying a new home – You can use a second mortgage to access the equity in your current house to buy a new one before your current house sells. To do this, you take out a first and second mortgage that can cover the profit you expect from selling your current home. Once the home sells, you can pay off both mortgages.  

Paying off debts – Taking out a second mortgage can be useful if you have high-interest debts such as credit cards or student loans. The second mortgage can be used to pay those off; you will be able to save money if the second mortgage has a lower interest rate. 

Cash-out refinance work around – If you need a large amount of money and the cash-out refinance option from your first mortgage isn’t enough, as they are often capped at 80% of your home’s value, then you can take out a second mortgage which you can get up to almost 100% of your home’s value. 

Be sure that you can afford a second mortgage before applying for one; defaulting on a mortgage could mean losing your home. 

How Does Getting a Second Mortgage Work?

Whether you are interested in getting a home equity loan or a home equity line of credit, the process of getting a second mortgage is similar to getting your first mortgage. You fill out an application, and your lender will have an underwriter review it, and then verify the value of your home. Once everything is verified, they can approve or reject your application. 

The requirements for getting a second mortgage, though, vary slightly from getting your first mortgage. With a second mortgage, you cannot exceed the lender’s combined loan-to-value ratio limits, which is usually 85%. 

Underwriters will also look at your debt-to-income ratio and house expense ratio, which helps determine how much house you can afford based on your pre-tax income. Since you will be having two house payments, it is crucial that you are able to afford this in order to avoid defaulting on the loan. Most lenders will require less than 43% for a DTI ratio

The final difference between getting a second mortgage and a first mortgage is that the first mortgage will affect how much you can borrow. With your first mortgage, you are only limited by your debt-to-income ratio and a few other factors. The second mortgage loan amount is based on how much equity you have. For example, if you have a home worth $300,000 and you’ve paid 200,000, you can borrow up to $55,000 based on the 85% limit.

Alternatives to Second Mortgages 

Although second mortgages can be a great resource for big purchases, there are also some alternatives to consider. If you don’t want to risk defaulting and losing your house, you could try taking out a personal loan or a credit card. Compared to a second mortgage, the downside is that they tend to have higher interest rates as they don’t use collateral, so you may pay more over time than with a home equity loan.

The other alternative to second mortgages is a cash-out refinance, which refinances your current mortgage into a larger loan so that you can access the equity in your home. This allows the term of your loan to stay the same, but you would have a higher monthly payment as with a second mortgage. 

Home Equity Loan vs Second Mortgage: Which is Better? 

When it comes to a home equity loan vs a second mortgage, they are the same idea. A home equity loan is a type of second mortgage along with a home equity line of credit. Each type of second mortgage will allow you to tap into the equity you have built into your home and use the cash for almost anything you would like. A home equity loan is a lump sum, while a home equity line of credit allows you to borrow as needed.

Whichever one you decide for your second mortgage – home equity loan or home equity line of credit – SouthEast Bank can help you understand the loan terms and answer any questions you might have.

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Information contained in this blog is for educational and informational purposes only. Nothing contained in this blog should be construed as legal or tax advice. An attorney or tax advisor should be consulted for advice on specific issues.