Home Equity Loan Vs. Mortgage: A Quick Guide

Navigating the world of home financing can often feel like exploring a maze, especially when trying to figure out the difference between a home equity loan vs a mortgage. Both options offer unique advantages for homeowners, but understanding their differences is important for making informed decisions that align with your financial goals.

This quick guide will explain the essentials of home equity loans and mortgages by helping you choose the path that works best for you and your financial well-being. Let’s dive deeper into the differences between a home equity loan and a mortgage so that you can make the most empowered decision in your home financing journey.

Home Equity Loans And Mortgages: A Brief Overview 

A mortgage is a type of loan used to buy property where the property acts as collateral for the loan. The borrower is required to pay back the loan amount along with interest over a specific time period. In case the borrower fails to make the payments, the lender can foreclose on the property to recover the loan amount.

However, a home equity loan is a type of loan taken out by a homeowner who has typically already paid off a significant portion of their mortgage and thus accumulated equity in their property. The homeowner can borrow from this equity and the home is used as collateral for the loan.

Home equity loans provide borrowers with a lump sum of money, which is repaid over a specific time period along with interest. These loans can be used for various purposes, such as home improvements, debt consolidation or any other major expenses. Unlike a mortgage, which is taken out solely to purchase or refinance a home, a home equity loan is taken out after a home is already owned. 

Here are some of the key differences and similarities between a home equity loan and a mortgage:

Mortgage Vs. Home Equity Loan: Borrower Requirements

While it can be challenging to distinguish between a mortgage and a home equity loan, understanding how they both work and borrower requirements can help highlight differences and better understand which one works best for you.

How A Mortgage Works

A mortgage is essentially a loan from a bank or financial institution that helps you cover the cost of a home. Here’s a basic idea of how the mortgage process works:

• Check your credit score
• Calculate your debt-to-income ratio (DTI)
• Find a property
• Shop around and compare rates
• Apply for preapproval
• Complete loan processing
• Submit a full application
• Go through underwriting process
• Accept funds and begin repayment

How A Home Equity Loan Works

A home equity loan is a type of loan that allows homeowners to borrow money against the equity they have built up in their property. Equity is the difference between the current market value of the home and the outstanding balance on the mortgage. The amount of money that can be borrowed is based on a loan-to-value ratio of 80% – 90% of the home's value. However, the amount of the loan and interest rate also depends on the borrower's credit score and other financial information and history.

Once approved, homeowners receive a lump-sum of money upfront, typically at a fixed interest rate, which they can use for various purposes, such as home renovations, debt consolidation, education expenses or other major financial needs.

Repayment terms for home equity loans typically range from 5 – 15 years, with borrowers making regular monthly payments that cover both principal and interest. Just like a primary mortgage, failure to repay according to the terms can result in foreclosure, as the home secures the loan.

Here’s some requirements for getting a home equity loan as of 2024:

• Need at least 20% equity in your home
• Credit score in the mid – high 600s
• DTI ratio of 43% or less
• Stable income
• Proof of income, tax returns, bank statements and property information

Is A Home Equity Loan A Mortgage?

 A home equity loan is actually a type of mortgage. The word “mortgage” refers to any loan that is secured by real estate. While its often used to refer to a loan used specifically to purchase a home, it technically includes any loan that is secured by real estate. A home purchase mortgage is essentially a home loan that is used to buy a property.

On the other hand, a home equity loan allows you to borrow money that you have already paid on your home and use it for various expenses or repairs. In essence, it involves borrowing against the value that has built up in the property through mortgage payments and appreciation.

It’s important to understand that a home equity loan is indeed a form of mortgage. This understanding helps in recognizing the financial implications and responsibilities that come with taking out such a loan. It leverages the value you've built in your home, offering a way to access lower-interest funds for large expenses, but it also requires careful consideration due to the risk of using your home as collateral.

Is A Home Equity Loan The Same As A Home Equity Line Of Credit?

A home equity line of credit (HELOC) is a flexible form of borrowing that allows homeowners to access funds based on the equity they have built up in their property. It is a revolving credit line, which means the borrower can take out money against the credit line up to a preset limit, make payments and then take out money again. Unlike a home equity loan, which provides a lump sum upfront, a HELOC operates more like a credit card with a preapproved credit limit. Homeowners can draw from this line of credit as needed, making required payments only on the interest from the amount they borrow.

Home equity loans usually have fixed interest rates, while HELOCs often have variable rates, meaning monthly payments can vary. Home equity loans generally require immediate repayment, while HELOCs usually have two phases (draw period and repayment period).

The first phase is the draw period, during which borrowers can make interest-only payments and access funds. The second phase is the repayment period, during which they must repay both principal and interest. HELOCs have variable interest rates, which means the interest rate can change over time, impacting monthly payments.

It's important to note that, like a home equity loan, a HELOC is secured by the borrower's home. This means that if the borrower fails to repay the loan according to the terms, it can lead to foreclosure. Also, since the amount borrowed can change, the borrower's minimum payments can vary depending on the credit line's usage.

When To Use A Mortgage Instead Of A Home Equity Loan 

A mortgage enables you to finance the purchase of a property over time with manageable monthly payments. However, it's important to note that there are several types of mortgages available in the market besides home equity loans. You can choose from various mortgage options that cater to your specific requirements and financial situation. Therefore, it's crucial to carefully consider your options and select the one that aligns with your long-term financial goals and budget.

When To Use A Home Equity Loan Instead Of A Mortgage

Homeowners can consider taking a home equity loan in various situations, such as planning for significant home renovations or investing in properties. A home equity loan allows you to access a lump-sum amount of money by leveraging the equity you have built in your home. This type of loan could provide lower interest rates as compared to other forms of loans. However, it's crucial to understand that home equity loans use your home as collateral. Therefore, it is essential to carefully assess your financial situation and ability to repay before deciding to go ahead with the loan.