When it comes to home loans, there are several options that lenders offer. Most people are familiar with the traditional mortgage, which provides the funds necessary to purchase a new house. Another popular type of home loan is the home equity loan, which is available to current homeowners who have built up equity in their property.
While both types of loans fall under the mortgage category, they are different in a variety of ways. Namely, a traditional mortgage is only available to prospective home buyers, whereas a home equity loan is only an option for borrowers who already own their house. If you are considering a mortgage or a home equity loan, here is what you need to know.
How Mortgages Works
A mortgage is a home loan that prospective house buyers can get from a qualified lender. If the buyer doesn’t have enough money to purchase a house in full using cash on hand, a mortgage provides the funds to buy the property. Typically, a mortgage is repaid with interest over a 15-year or 30-year period.
In order to get a mortgage, the home buyer must meet certain requirements. For example, the lender will usually ask to see proof of stable income, verification of full-time employment, a good credit score, and a debt-to-income ratio of less than 50%. You can apply for a mortgage alone, or with another person.
One important thing to know about mortgages is that they are a secured loan. When you get a mortgage, your house is used as the collateral. If you fail to repay the mortgage principal and interest, the lender has the legal right to repossess the property, which can then be foreclosed on or sold at auction.
How a Home Equity Loans Works
A home equity loan is a type of mortgage that is available to people who already own their home and have equity in the property. Equity is simply the difference between your home’s current value and the remaining balance on your mortgage.
Sometimes called a second mortgage, a home equity loan allows you to leverage your collateral to borrow money. The money can be used for any purpose, whether you want to renovate your home, send a child to college, or need to pay for emergency expenses, like medical bills. The loan funds are deposited into your bank account in one lump sum.
With a home equity loan, borrowers are required to repay the loan principal over a set period of time, plus interest at a fixed rate. Home equity loans also come with closing costs. Like a regular mortgage, home equity loans are secured, and your home is used as the collateral in case you can’t repay the money. If you default on the loan, your home can be repossessed.
Difference between a home equity loan and a mortgage
Home equity loans and mortgages share some similarities, but they are very different types of home loans.
First, you can only qualify for a traditional mortgage if you are purchasing a new home. If you already own a home and have equity in the property, you can only qualify for a home equity loan. Prospective home buyers can’t get a home equity loan, and current homeowners can’t get a traditional mortgage.
The second major difference is how you can use the money. With a traditional mortgage, the money you borrow can only be used to purchase a property. With a home equity loan, however, the money can be used for any purpose. In some ways, a home equity loan is similar to a personal loan, but your house is used as the collateral.
Both a traditional mortgage and a home equity loan must be repaid with interest over a fixed period of time. However, a home equity loan usually has a lower interest rate than a purchase mortgage. Also, a home equity loan always has a fixed interest rate. With a purchase mortgage, you can choose between a fixed-rate loan and an adjustable-rate loan.
There are also different tax implications with a home equity loan vs. mortgage. When you have a traditional mortgage, the interest is tax deductible, up to a certain amount that is determined by the IRS. On the other hand, you can only deduct interest payments on a home equity loan if you use the money for home renovations, or to purchase a second property.
Ultimately, a mortgage and home equity loan are both good options, depending on which one you qualify for. However, make sure to review the pros and cons of each one before you borrow money. You should also consider shopping around for home loans to find the lowest interest rate and the most favorable loan terms.