A second mortgage and home equity loan both use your loan as collateral. Many people confuse the two loans, though. A second mortgage and home equity loan aren’t the same thing. They have similar concepts – they are both a mortgage and both use your home as collateral, but the similarities end there.
We help you understand the differences below.
What Second Mortgages and Home Equity Loans Have in Common
Second mortgages and home equity loans have a few things in common:
- They both have second lien position – Your first mortgage has first lien position. In other words, if you miss your payments for 90 days or more, the bank can take possession of your property. They sell your home and pay themselves back using the proceeds from the sale. The first mortgage lender receives payment first.
- Your house is your collateral – If you don’t make your payments, the bank may start foreclosure proceedings. It’s not common since they have a second lien position, but it’s a possibility.
- You make payments monthly – Each loan type requires monthly payments. You’ll have a due date and a grace period. If you make your payments more than 30 days late, the lender may report the negative information to the credit bureaus.
- You need equity – Both second mortgages and home equity loans require a specific amount of equity. Each lender/loan program has different requirements. If you don’t have equity, though, neither loan is an option.
How are Second Mortgages and Home Equity Loans Different?
Technically, a second mortgage and home equity loan are the same thing. They are both ‘second liens’ on your property. Now, you have two choices for your second lien, though:
- Home equity line of credit
- Home equity loan
If you opt for the home equity line of credit, you are talking about a credit line rather than a lump sum loan. The credit line works much like a credit card. The bank gives you a specific credit line. You can use some of it, all of it or none of it. Here’s where the differences begin.
If you spend some of it, you owe interest only on the amount you withdrew. Let’s say, for example, the bank gave you a $100,000 credit line. You used $10,000 right away. You pay interest on the $10,000. That’s it. If you spend more of your remaining $90,000 credit line, your payments increase. You can pay more than the minimum payment. You can pay back the principal. If you do, you can reuse the credit line, just like on a credit card.
After the first 10 years, the credit line portion of the loan closes. You then owe principal and interest payments for the next 20 years. You cannot use any of the credit line any longer.
A second mortgage or home equity loan is a lump sum loan. You receive the entire amount borrowed at the closing. If you borrowed $100,000, you receive $100,000 at one time. You make principal and interest payments right away and throughout the life of the loan.
Do You Need Equity for a Second Mortgage?
As we stated above, you need equity for either type of mortgage. Lenders typically lend up to 80 percent of the home’s value minus any first mortgage outstanding.
For example, your home is worth $300,000 and your first mortgage has a balance of $150,000. You can borrow up to:
$300,000 x .80 = $240,000 – $150,000 = $90,000
You can borrow up to $90,000, but you don’t have to take the full amount. Of course, you must qualify for the loan too.
Is a Second Mortgage a Good Idea?
Sometimes a second mortgage is a good idea. It depends on the reasons you want one as well as the loan’s terms.
Typically, if you use the second mortgage for any of the following, it may make sense:
- Making home improvements
- Consolidating debt (if the interest rate is lower)
- Using the second mortgage to avoid Private Mortgage Insurance
- Making a large purchase that would require a personal loan at a higher rate
Evaluating the loan’s terms helps determine if the loan is a good idea. For example, if you have a couple of zero percent interest rate credit cards, consolidating that debt into a second mortgage wouldn’t make sense.
On the other hand, if you have credit cards with high APRs, you may save money consolidating the debt into your home’s equity.
A second mortgage, home equity loan, and home equity line of credit may help you reach your financial goals. Shop around to find the deal that offers the best terms, helping you reach your goals faster.