Oftentimes there is confusion among potential homeowners as to the difference between home equity loans vs mortgages. They are not the same, and it’s important to understand which loan product is right for your needs.
A mortgage is a loan that an individual receives from a lender to pay for a new home. The home is used as collateral (something pledged as security for repayment) for the loan and the lender “has a claim” to the home until the debt is repaid. A mortgage is repaid over an agreed-upon number of years, with interest, until the homeowner owns the property free and clear.
The equity in your home is the difference between your home’s market value and the amount you still owe on your home. Home equity loans allow homeowners to borrow money based on the amount of equity they have built in a home. You build equity in a home by making mortgage payments and reclaiming more ownership of your home from the lender. A home equity loan is sometimes referred to a “second mortgage.”
How Home Equity Loans Work
Here’s an example of how home equity loans work. If your home’s market value is $250,000 and you still owe $180,000 on your mortgage, you have built up $70,000 in equity. A home equity loan allows you to borrow against that $70,000. Depending on the terms that a lender offers, you may be able to use the entire amount of equity in your home or just a percentage of your total equity. The Home Equity Loan is in addition to your mortgage, so you will now have two different loan payments – the mortgage and the home equity loan.
Options for Home Equity
There are two options for borrowing against the equity you’ve built in your home:
Home equity loans — This option provides you with a lump sum of money up front. You’ll have a fixed repayment schedule and a fixed interest rate. Terms can extend as far as 20 years.
Home equity lines of credit (HELOC) — This option allows you borrow money as you need it, up to the agreed upon amount and term (number of years) you’ve determined with your lender. With a line of credit, your payments are based on only the amount used and the interest is variable, so your repayment amount will fluctuate over the length of the loan.
Best Uses for a Home Equity Loan
Another difference between home equity loans vs. mortgages is how you can use the loan. With a mortgage, the money must go towards the purchase of a property. With a home equity loan, however, you can use the money for whatever purpose you’d like. Here are three of the smartest ways to use your home equity loan.
1. Home Improvements
Home improvement is one of the most popular reasons that homeowners take out a home equity loan. Whether you’re putting on an addition, updating a kitchen or bathroom, or making other upgrades, a home equity loan provides you with a low-interest option for adding increased value to your home.
2. College Education
When you use your home’s equity to finance your child’s education you can borrow more money than you could with traditional student loans. Additionally, you can borrow at a lower interest rate.
3. Paying Down High-Interest Debt
You can use your home equity wisely to pay off high-interest debt. This allows you to replace multiple high-interest payments with a single low-interest payment. However, home equity loans are secured and they are tied to the ownership of your home. If racking up outstanding debt is a reoccurring problem, then this may not be the best use of your home’s equity.