Home Equity Loan vs Second Mortgage

Every homeowner wants to clear their mortgage or pay off as much of it as they can. It gives them numerous options with regards to selling up and moving on, as it means they can use the money to make a bigger down payment, buy a much bigger house, and then pocket the rest of the cash. But what happens if a move isn’t on the horizon, how can you benefit from having all that equity?

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This is where a second mortgage comes in. It’s not without its problems, but if you have a lot of equity, it’s a great way to secure a lot of cash in a hurry.

Home Equity Loan vs Second Mortgage

There is some confusion regarding second mortgages and equity loans, with many consumers trying to compare the two. In fact, a home equity loan is merely a type of second mortgage, as is a home equity line of credit, also known as a HELOC. 

Whether an equity loan or line of credit is right for you depends on how much money you need, and how much equity you have.

What You Need to Know

Before we look at the two main types of second mortgage, there are a few things you need to know. These include your debt-to-income ratio, your current equity stake (also known as loan-to-value ratio), and your credit score. All of these will play a major role in determining whether or not you will be accepted and if so, how much you will get.

If you already know all these things, you can skip to the next section.

Your Home Equity

Your equity stake is essentially the amount of the house that you own. The term “loan-to-value” may also be used here, referring to the value of the loan (mortgage) in relation to the value of the property.

Contrary to what you might think, your equity is not the purchase price minus the amount that you have repaid. Instead, it is the current value of the house minus what you have already paid.

For example, let’s imagine that you bought a $200,000 house 10 years ago and used a 10% down payment, thus acquiring a mortgage of $190,000. The house is currently valued at $250,000 and you have $125,000 left on your mortgage balance. This means that you have a loan-to-value ratio of 50%, as the balance ($125,000) is 50% of the value ($250,000) and the remaining share is yours.

Your Debt-to-Income Ratio

You probably know a little about your debt-to-income ratio already, as it is a big part of the mortgage application process. If not, here is a little refresher.

The debt-to-income ratio is used to determine your affordability and compares your gross income to your total debt. Lenders use the debt-to-income ratio to calculate how much of your income is being spent on debt and to judge whether or not you can afford the additional debt payment you’ll be asked to make every month.

Most mortgage lenders require a debt-to-income score of no more than 43%, others will allow you to go as high as 50%, which means that 50% of your income is being spent on debt.

To calculate this figure, simply add all your income, including your salary and investments, and then compare this to all debt payments, including credit card debt, student loans, personal loans, and car loans. For instance, if you make $5,000 a month before tax, earn an additional $1,000 in investment income, and spend $3,000 on minimum monthly payments, your debt-to-income ratio is 50%.

By paying off more of your debts or increasing your income, you can reduce your debt-to-income ratio and increase your chances of being accepted for an equity loan. More importantly, you will also inject some much-needed stability into your financial situation, because the higher your debt-to-income ratio is, the greater your risk of persistent debt and bankruptcy.

Your Credit Score

As always, your credit report and credit score are essential when you’re applying for new credit. The lower your score is, the less chance you have of being accepted and the more likely you are to be given higher interest rates. By reducing your credit score, you’re more likely to be accepted and offered low interest rates.

A few points can make all the difference and it’s always worth spending some time fixing your credit score before you apply.

All three major credit bureaus (Experian, Equifax, TransUnion) are required to give you a free credit report every year. Use these free services to understand where you stand, giving you a foundation on which you can build. If there are any issues, fix them; if your score is low, improve it.

Home Equity Loans

  • Interest Rate: Fixed Rate
  • Payment: Lump Sum
  • Interest Only Option: N/A
  • Minimum Equity Needed: 15% to 20% (may differ)
  • Minimum Credit Score: 620
  • Debt-to-Income Ratio Required: 43%

A home equity loan is simply a loan leveraged against the equity you have in your home. The amount of money you’re offered will depend on your equity and the value of your home and your interest rate will be dictated by your credit score, among other things.

It’s a secured loan, which means the rates and fees are generally much more favorable than you’ll be offered with unsecured personal loans, and you’ll get all the money as a lump sum. You’ll be charged a fixed monthly payment on top of your primary mortgage (if it has not yet been paid in full) and this will never change.

If anything happens and you fail to keep up with payments, your home will be at risk. The primary mortgage lender will take priority if anything happens, but the second mortgage provider will seek their pound of flesh once those initial debts have been paid.

Pros and Cons

A home equity loan can give you a large lump sum when you need it, and in exchange, it will offer you a rate that is far better than what you’ll get with a personal loan. However, if your original home mortgage remains, you’ll be given another sizeable monthly payment to make and this could bleed you dry financially.

What’s more, if your equity share is very small, you may still be paying private mortgage insurance (PMI), and on top of this, you’ll also have property taxes, homeowner’s insurance, and other bills to consider. If your debt-to-income ratio is anywhere near the maximum threshold, and you’re not using the lump sum to clear debt, you should seriously reconsider.

Your house is at risk, and it’s a house you may have spent several years paying for. 

Home Equity Lines of Credit

  • Interest Rate: Fixed Rate and Adjustable Rate
  • Payment: Revolving Line of Credit
  • Interest Only Option: Yes
  • Minimum Equity Needed: 15% to 20% (may differ)
  • Minimum Credit Score: 620
  • Debt-to-Income Ratio Required: 43%

A home equity line of credit, or HELOC, works in a very similar way to a home equity loan. The difference is that it offers a credit line you can tap into as needed, with all credit leveraged against the home equity share.

There are two periods to a HELOC. The first of these is the draw period, during which time you will draw money from the house and may only be required to pay the interest on the money you borrow. Once this period is over, the repayment period begins, and you’ll start paying back the balance and all accumulated interest debt.

Pros and Cons

A HELOC has many of the same risks associated with a home equity loan. It may be more preferable if you envisage needing lots of small sums of money as opposed to one big one, but ultimately, your equity is still at risk and your debt obligations will increase.

Some users also run the risk of overspending. With a lump sum loan, the average consumer is more likely to borrow only what they need, whether that be the cost of a vacation and spending money or the total amount needed to clear debt balances. With a HELOC, they’re prone to taking lots of little bits here and there, dipping into the equity whenever a cost arises and ultimately spending more than they can afford to comfortably repay.

It’s for this reason that credit card debt is so common, and many consumers overspend on everyday expenses. When they’re making a single large purchase, they’re in control and can think clearly, but when they’re making lots of smaller ones, they lose track.

How to Use a Second Mortgage

No restrictions or rules govern how you spend your home equity loan or line of credit. However, some methods are riskier than others and could lead to massive and incredibly costly mistakes:

Debt Consolidation

One of the best uses for a second mortgage is to clear unsecured debt balances. These debts typically charge huge amounts of interest and fees and while it can be a scary prospect to add more debt on top, if it’s used to clear the original balances you should be much better off overall.

You will pay a much lower interest rate on a home equity loan or line of credit, potentially saving you thousands of dollars in interest when using that loan to clear all debt. Unless you have very little equity, a lot of debt or your home’s value has plummeted, you should be offered the amount you need to clear debt.

Debt consolidation is also a good option for cash-out refinancing and even reverse mortgages, which offer similar benefits and terms.

Large Expenses

Many homeowner’s use equity loans and credit lines to cover weddings, honeymoons, funerals, and other big expenses. Many of these happen without warning and can cost huge amounts of money. If you’re close to someone who dies and they don’t have savings or insurance, the responsibility may fall on you to cover the $8,000+ that the average funeral costs. If your child is getting married and needs a helping hand, you may feel obliged to help them cover the $30,000+ that the average wedding costs.

This sort of money isn’t easy to come by through other means, so home equity may be the only viable option for you.

Vacation

We’re not going to suggest that you should give up your dream of taking a trip around Europe, flying first-class to Australia or spend a few weeks in the Bora Bora. Yes, it’s bad debt, and yes, it’s very risky, but experiences like this are what life is for.

However, we would recommend that you look at some alternatives first and don’t rush in. If you’re young and don’t have much equity, wait a few years and focus on saving money and building equity. If you’re older, don’t believe you’ll have much time and don’t have any savings to tap into, it’s a more viable option.

Education

In recent years there has been a sharp increase in the number of 60+ student loan borrowers, as parents and grandparents seek to help their kin through college. 

Student loans generally offer better terms and less risk than home equity loans and can be taken directly by the student. However, if other costs need to be covered or they need a bar loan or sizeable living costs, these secured loans could help.

Home Improvement

You can use home equity loans to improve your home, making big renovations, adding new rooms, and generally improving its value. There are some tax breaks available when you do this, as many of the improvements and costs may be tax deductible, and you could also improve the future value of the home, which means the loan will pay for itself.

It’s highly unlikely that using a home equity loan to make home improvements would work in the short term, but if you get a good return on your investment and are prepared to wait several years for that value to increase and your debt to reduce, it may begin to look like a very smart move.