There’s some confusion surrounding the terms “second mortgage” and “home equity loan.” So, let’s be clear: A home equity loan is a type of second mortgage. But that’s not all you should know.
What is a second mortgage?
A second mortgage is another home loan taken out against an already mortgaged property. They are usually smaller than a first mortgage.
The two most common types of second mortgages are home equity loans and home equity lines of credit (HELOC).
Like a first mortgage, your home is used as collateral for a second mortgage. Should a foreclosure happen, the first mortgage lender is first in line to get repaid. The second mortgage lender is repaid next.
Good to know:
Since second mortgages are riskier for the lender, interest rates on them tend to be a bit higher than interest rates on first mortgages.
What is a home equity loan?
A home equity loan is a type of second mortgage that lets you borrow against your home’s value. You’ll get the proceeds from a home equity loan in a lump sum — similar to a personal loan — and the loan’s interest rate will be fixed.
By contrast, a HELOC allows you to borrow smaller sums as needed, and the interest rate is usually variable. Traditionally, you’ll need to retain 20% equity in your home to qualify for a home equity loan.
Here’s an example of how someone could access their equity through a home equity loan:
- Home value: $250,000
- Mortgage balance: $150,000 or 60% of the home’s value
- Equity to retain: 20% or $50,000
- Equity available to borrow: 20% or $50,000
Tip:
Some lenders might allow you to retain as little as 10% equity when you take out a second mortgage, but they might also require you to pay for private mortgage insurance or charge you a higher interest rate.
While a home equity loan would give you $50,000 upfront in the above example, a HELOC would give you access to a $50,000 line of credit. You might never borrow the full $50,000, and you’ll only pay interest on the amounts you actually borrow.
Here are the most important differences between a home equity loan and HELOC:
An alternative to second mortgages
One alternative to a second mortgage is a cash-out refinance. With a cash-out refi, you pay off your existing mortgage with a new, larger mortgage and pocket the difference.
Tip: You can use the cash from a cash-out refinance however you want, just like you can with a home equity loan or line of credit. Like those options, you’ll need to have 20% equity left after the cash-out refinance unless you’re willing to pay private mortgage insurance.
The biggest benefit to choosing a cash-out refinance over a second mortgage is that cash-out refinance rates tend to be lower. This is because a cash-out refi is a first mortgage. The biggest drawback is that since you’ll be getting a larger loan, your closing costs, particularly the origination fee, may be higher.
