Whether you’re a first-time homebuyer or a seasoned real estate investor, it’s important to understand the differences between two popular loan options: home equity loans and mortgage loans.
Vaster is here to tell you everything you need to know about these two loan options so that you can make the best possible decision for your financial situation and financial goals.
What Is a Home Equity Loan?
A home equity loan — also known as a second mortgage or equity loan — is a loan in which borrowers to use the equity of their home as collateral. The funds from a home equity loan can be used for purposes including (but not limited to) home renovation costs, medical expenses, education expenses, and more. Home equity loans can also help finance a second home or an investment property.
However, you can’t get a home equity loan until you have at least 20% equity in your home. Additionally, most lenders only permit you to borrow 80% to 85% of your home equity.
What Is a Home Equity Line of Credit?
A home equity line of credit, at first glance, may look the same as a home equity loan, but those looks are deceiving: Essentially, a home equity credit line acts like a credit card where you have a borrowing limit and can access the funding that you need when you need it over a set period of time.
A home equity loan gives the holder a lump sum of cash upfront based on your home equity and your lender’s requirements. Subsequently, home equity loans tend to rack up more interest compared to home equity lines of credit since you’re taking out a large lump sum all at once rather than simply borrowing money as you need it.
Speaking of interest rates, it’s essential to note that home equity lines of credit tend to have variable interest rates and variable payments. In contrast, home equity loans tend to have fixed interest rates and fixed payments.
What Is a Mortgage Loan?
A mortgage loan is a loan you use when you’re initially buying a home. Lenders only provide a mortgage loan based on the appraised value of your home you’re looking to purchase. Furthermore, mortgage lenders only provide you with up to 97% of the home's purchase price, depending on your loan type.
What Are the Different Types of Mortgage Loans?
As you now know, there are many different types of mortgage loans available depending on your financial situation and the type of property you’re purchasing.
Conventional mortgage loan: Conventional mortgage loans are the most common type of mortgage loan that allows you to put down as little as 3% of the home’s purchase price. However, conventional mortgage loans come with private mortgage insurance or PMI for down payments of less than 20%.
Jumbo mortgage loan: Jumbo mortgage loans are used to finance the purchase of more expensive homes that are outside of federal lending limits. In the majority of the United States, this limit is $647,200. Note that it can be higher in high cost of living locations like Southern California, Boston, New York City, Washington, DC, Alaska, and Hawaii.
Government-backed mortgage loans: Government-backed mortgage loans like FHA loans, VA loans, and USDA loans are insured by the federal government in the event of default. This insurance lowers the risk taken on by lenders and incentives lending to those who may not qualify for conventional mortgage loans.
Non-qualified mortgage loans: A non-QM loan isn't held to the standards set by Fannie Mae and Freddie Mac A non-QM loan could be ideal for individuals who might have a high debt-to-income ratio or a lower credit score. Those without W-2s, like freelancers or self-employed individuals, might prefer a non-QM loan since this loan offers alternative income verification methods. Non-qualified mortgages aren’t backed by the government and might have higher rates and fees, but require less documentation
Private mortgage loans: Private loans can be used by individuals and corporate entities and are commonly used to finance investment properties. These loans are easier to qualify for as they do not require credit history or income verification. Private loans are favored when the proposed down payment is at least 35%, credit scores might not meet traditional criteria, or the prospective buyer doesn’t have a series of W-2s or related employment documents.
What Are the Differences Between a Home Equity Loan and a Mortgage Loan?
Now that you’ve reviewed the basics of home equity loans and mortgage loans, let’s dive even deeper and discuss the key differences between these two popular loan options:
Difference #1: Uses
Perhaps the biggest difference between a home equity loan and a mortgage loan comes down to the use of the loan. A mortgage loan is used to initially purchase a home or refinance a home. On the other hand, a home equity loan is used after you have purchased a home to cover the cost of home improvement renovations, starting a business, going back to school, etc.
Difference #2: Eligibility
Another difference between a home equity loan and a mortgage loan relates to eligibility. While both home equity loans and mortgage loans consider factors like credit score, income, and debt-to-income ratio (DTI) when determining eligibility, home equity loans also require that you have at least 20% equity in your existing home to qualify.
Difference #3: The Loan’s Interest Rates
Home equity loans and mortgage loans also come with different interest rates. Although home equity loans typically come with lower rates compared to other types of personal loans, these interest rates are still usually higher than those that come with mortgage loans.
At the same time, keep in mind that interest rates vary for all loan types based on your credit score, location, loan term, and other factors.
Difference #4: Loan Terms
The loan term is another difference between home equity loans and mortgage loans. Most mortgage loans, like conventional loans, come with longer terms of 30 years, although 15-year terms are also available.
Alternatively, home equity loans come with shorter terms that can range between five and 15 years. This loan type usually comes with higher interest rates.
Difference #5: Tax Deductions
It’s critical to consider differences in tax deductions between home equity loans and mortgage loans. If you took out your mortgage loan prior to December 15, 2017, you’re able to deduct the interest on your loan amount up to $1 million. If you took out your mortgage loan after December 15, 2017, you’re able to deduct the interest on your loan up to $750,000.
If you’re using a home equity loan to “buy, build, or substantially improve the home that secures the loan,” you’re able to deduct the interest on your loan up to $750,000. Previously, you were able to deduct the interest on your loan no matter how the money was used. The new rule applies to home equity loans from 2018 to 2025.
What Are the Pros and Cons of a Home Equity Loan?
Some of the pros of a home equity loan include…
Flexibility to use the funds as you wish to further your financial goals like purchasing an investment property, renovating your home to build equity, or starting your own business.
Fixed interest rates translate into fixed payments and flexible terms that range from five to 15 years.
Relatively lower interest rates compared to other types of loans that you would typically use to fund investments, education, businesses, etc.
Some of the cons of a home equity loan include…
Your home is used as collateral for your home equity loan, so you’re putting your home at risk if you’re not able to make your loan payments.
You will end up with essentially two mortgage payments since home equity loans are also known as “second mortgages.”
You will pay more in interest with a home equity loan compared to a home equity line of credit since you’re borrowing a lump sum.
What Are the Pros and Cons of a Mortgage Loan?
Some of the pros of a mortgage loan include…
Helps you initially secure a property, after which you can then build equity and eventually sell for a profit or use your equity for other purposes.
Many different types of mortgage loans to choose from based on your financial situation and financial goals.
Long terms, fixed interest rates, and relatively low interest rates make mortgage loans more affordable and predictable than other types of loans.
Some of the cons of a mortgage loan include…
Like home equity loans, your home is used as collateral for your mortgage loan, which puts your home at risk if you’re not able to make your loan payments.
Mortgage loans typically come with long terms, making monthly payments more affordable but increasing the total amount of interest paid throughout the entire term.
Mortgage loans can be difficult to qualify for if you have poor credit, inconsistent income, and substantial debt (like credit card debt).
When Should You Use a Home Equity Loan or a Mortgage Loan?
Everyone’s financial situation is different. Therefore, it’s important to choose the loan product that’s best for your financial situation and financial goals.
Here’s some guidance to help you choose between a home equity loan and a mortgage loan so you can make the best personal finance decisions:
You may want to use a home equity loan if…
You currently own a home and have at least 20% equity in said home.
You need extra money to cover remodeling costs, education costs, medical costs, etc.
You want to borrow with a lower interest rate compared to other types of personal loans.
Alternatively, potential homeowners may want to use a mortgage loan if…
You’re looking to initially purchase a home.
You’re looking for the lowest possible interest on your mortgage rate.
You’re looking for a longer-term loan of up to 30 years.
The Bottom Line on Home Equity Loans and Mortgage Loans
Whether you’re purchasing your first home or your tenth home, Vaster can help make it happen with our wide range of lending solutions. Reach out to our lending experts to see what’s possible when you work with an experienced, flexible, and responsive lender.