What’s the difference between a home equity loan and a mortgage?
A mortgage is a loan used to purchase or refinance a home. If you already own your home and want to pull cash from your equity, you can use a special type of mortgage called a cash-out refinance to do so.
A home equity loan is a little different. Home equity loans are a type of ‘second mortgage,’ meaning they’re not used to buy or refinance a home. Rather, they’re used only to withdraw equity.
Both loan types are secured by your home’s value. So they offer low rates and affordable financing when you need to borrow a large amount of cash.
The right loan for you will depend on your personal finances and your current mortgage. Here’s how to decide.
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There’s a lot to consider when deciding between a home equity loan and a mortgage. You’ll want to evaluate your options carefully before choosing one or the other.
Our best advice boils down to:
- A mortgage (cash-out refinance) is likely best if you want to cash-out home equity and change the interset rate or terms on your current home loan
- A home equity loan is likely best if you need to cash-out equity but don’t want to re-start your existing home loan (maybe because you already have a low interest rate or you’re close to paying the home off)
If you’re not sure which type of mortgage is best for you, connect with a mortgage lender. Your loan adviser can help you compare interest rates, loan amounts, and long-term costs to find the best loan for your situation.
How a cash-out mortgage works
If you want to pull equity out of your home using a mortgage, the type of loan you’ll use is a cash-out refinance.
Cash-out refinancing involves replacing your existing home loan with a new mortgage. The new loan has a larger balance than your existing one, and the difference is returned to you as cash-back at closing.
A cash-out refinance is a “first lien” or “primary mortgage,” meaning it’s slightly lower risk than a home equity loan. As a result, cash-out refi rates are typically a little lower than home equity loan interest rates.
However, you’ll have a bigger loan amount and higher mortgage payments because you’re refinancing the entire loan amount. And you’ll start your loan term over. That means you could end up paying more interest in the long run than you would have if you’d kept your original mortgage in place.
On the upside, if your existing mortgage rate is above current market rates, a cash-out refinance could potentially help you drop your rate and save some money over the life of the loan.
How a home equity loan works
A home equity loan (HEL) is a type of second mortgage. That means you leave your original home loan in place and take out a second, smaller mortgage alongside it. This results in two separate monthly mortgage payments — one on your primary home loan and one on your home equity loan.
It’s likely that those two monthly payments combined will be bigger than the one you’d face with a cash-out refinance. So, why would anyone choose a home equity loan?
Well, there are a few good reasons. A big one is that your HEL will typically have a shorter loan term. And that means a shorter period during which you’re paying interest, which should save you money in the long run.
How a home equity like of credit (HELOC) works
Home equity lines of credit (HELOCs) are another type of second mortgage that let you borrow cash from your home equity without changing the terms on your first mortgage.
In some ways, HELOCs are more like credit cards than home equity loans. Because you get a credit line you can borrow against, repay, and borrow again. And you pay interest only on your outstanding balance.
And HELOCs differ from HELs in another way.
Home equity loans are installment loans, like a mortgage or auto loan. You borrow a lump sum and pay it back in equal installments over the loan’s fixed term, usually at a fixed interest rate. So they’re predictable and easy to budget for.
But, with HELOCs, you typically get a loan in two parts.
- During your “draw period” (often 10 years but sometimes five or 15) you pay only interest, usually at a variable interest rate, on your current balance
- Then comes the “repayment period,” which can often last for half the draw period. During that time, you can’t borrow any more but have to zero your debt before that period ends, while keeping up interest payments
HELOCs can be great for people whose incomes fluctuate a lot, such as contractors, freelancers, and those in seasonal jobs. But they’re dangerous for those who are bad money managers. If you tend to max out your credit cards, you may well do the same with a HELOC.
Home equity loan vs. mortgage refinance: Pros and cons
So, what are the pros and cons of a home equity loan vs. mortgage? Here’s a brief overview:
|Home Equity Loan||Mortgage (Cash-Out Refinance)|
|Interest Rates||Higher rates||Lower rates|
|Loan Terms||10, 15, or 20 years||30 or 15 years|
|Max. Loan Amount||Up to 85% of home value||Up to 80% of home value|
|Closing Costs||2-5% of borrowed equity amount||2-5% of entire mortgage|
Now let’s look at their main characteristics side by side.
Interest rates on home equity loans tend to be a bit higher than those for cash-out refinances. There’s a technical reason for that. Namely, HELs are “second liens.” And that means they’re riskier for mortgage lenders because they’d get paid second in the event of a foreclosure.
However, the differences in rates are typically minor. And the loan amount on a home equity loan is smaller than a mortgage refinance— so you’re paying interest on a smaller sum.
In addition, both HELs and cash-out refinances are fixed-rate loans. So your rate and loan payments are predictable.
Regardless of which loan type you choose, you should shop around for the best interest rate on your loan. Compare personalized rate quotes from at least 3 lenders to find the best deal.
Closing costs for cash-out refinancing and home equity loans are roughly the same in percentage terms: often 2-5% of the loan value. But, of course, your loan amount is smaller with a HEL. So the total upfront fees are much lower.
Both loan types can last for up to 30 years. But home equity loans rarely do. More commonly, they have terms of five, 10, 15, or 20 years. If you want a mortgage refinance, on the other hand, your new loan will usually last 30 years.
Terms of 10-25 years are also available for cash-out refinancing. However, shorter-term loans have much higher monthly payments because you’re repaying the same loan amount in a shorter period. And that’s a deal-breaker for many borrowers, especially those who already have a high debt-to-income ratio (DTI) or low monthly cash flow.
A cash-out refinance to a new 30-year mortgage can present issues, too.
For instance, if you’ve already paid down your existing 30-year loan for 10 years, and you refinance to a new 30-year one, you’ll be paying for your home over 40 years instead of 30. Worse, you’ll be paying interest on a large sum for 40 years instead of 30. And that’s expensive, even at a lower interest rate.
So taking a 10- or 15-year home equity loan brings a big advantage. You still pay down your home over 30 years. And you’re highly likely to pay less interest in total across both loans, despite the difference in rates.
Amount of equity you can cash out
The amount of money you can withdraw from your home depends on your current loan balance and the value of your home.
When you get a cash-out refinance, you typically have to leave at least 20 percent of your home’s value untouched. That means your new loan can only be up to 80 percent of your home’s value (known as an 80% loan-to-value ratio).
The loan also has to pay off your existing mortgage. So your maximum cash-back is equal to 80 percent of your home’s value minus your current loan balance.
- Your home’s market value is $400,000
- Your current mortgage balance is $200,000
- The max. cash-out loan amount is $320,000 (80% x $400,000)
- Your max. cash-back is $120,000 ($320,000 – $200,000)
Only VA loans (mortgages for veterans and service members) let you do a cash-out refinance whereby you take out 100% of your equity.
The calculation is similar for home equity loans.
You aren’t using the new loan to pay off your existing one. But the first mortgage and second mortgage combined usually can’t be above 80 percent of the home’s value. So the math works out the same.
However, some home equity loan lenders are more flexible and will allow you to borrow up to 85 percent of your home’s value.
How you can use the funds
Neither cash-out refinances nor home equity loans dictate how you can use the funds. It’s totally up to you.
However, you typically want to use the money for something with a good return on investment. That’s because you’re paying interest on the cash and it’s secured by your home.
Popular uses for home equity include home renovations and debt consolidation (using the money to pay off high-interest personal loans or credit card debt).
Possible tax advantages of a cash-out refinancing
According to CNBC, cash-out refinance loans may be tax-deductible for eligible borrowers:
“Homeowners may also be able to deduct the interest on the first $750,000 of the new mortgage if the cash-out funds are used to make capital improvements (although since fewer people now itemize, most households won’t benefit from this write-off).”
Now, we aren’t tax advisers. So you must take your own advice from a professional before relying on that information.
But it may be that you are able to deduct for money spent on home improvements. So check it out if that’s why you want to borrow. Because it could be a decisive factor in your personal home equity loan vs. mortgage analysis.
Faster money if you need to cover pandemic expenses
By the way, federal regulator the Consumer Financial Protection Bureau last year made it quicker to access funds through cash-out refinances and HELs if you need money urgently to cover pandemic-related expenses. If this applies to you, read this article.
When to use a mortgage over a home equity loan
Choosing a cash-out refinance over a home equity loan can be a good way to keep your monthly expenses low. Remember that payments are typically cheaper because you’re only paying one mortgage rather than two.
A cash-out refinance is also the better option if you need to refinance anyway. Suppose your current mortgage rate is 4% but you could refinance to a 3% one. You’d slash your monthly payments. And your savings would soon pay for your closing costs.
Of course, if you take a lot of cash out with your refinance, you may still end up with a higher monthly payment. But you’ll have that lump sum, too. And you can do anything you like with the funds, just as with a home equity loan.
When to use a home equity loan instead of a mortgage
A home equity loan is typically a better choice than a cash-out refinance if your current mortgage is almost paid off, or if you already have an ultra-low mortgage rate.
By choosing a HEL, you can tap your equity without extending the term or changing the rate on your current loan.
You might also opt for a home equity loan if you can afford a higher monthly payment and want to save more in the long run. Remember that a HEL will likely cost more month-to-month — but you’ll pay it off a lot sooner than a cash-out mortgage.
You’ll also save on closing costs. And, while the interest rate you pay may be higher, the fact you’re borrowing less for a shorter period typically means you’ll be better off over the long term.
You can use our refinance calculator to run your numbers.
Can you have a home equity loan without a mortgage?
Yep. If you’ve already paid off your mortgage or bought the home with cash, you can still get a home equity loan. Or a new mortgage. Indeed, providing you can afford the monthly payments and have an OK credit score (or better), it should be very easy for you to qualify.
You may even be able to borrow up to 80% or 85% of your home’s value as cash. But, if you want that much, you’ll likely prefer the mortgage route. And you’ll certainly want to think hard about taking on that much debt.
Home equity loan vs. mortgage: The bottom line
Chances are, this debate closed down for many readers when they learned that a cash-out refinance would almost certainly be less costly in the short term. Many of us, especially if we’re younger, have no choice but to focus on minimizing our current outgoings and letting the future take care of itself.
But those who can afford to take a strategic view of their finances may well find that a home equity loan saves them money in the long run. And, for them, that really is the bottom line.