It's not surprising that some homeowners confuse the terms "second mortgage" and "home equity loan." After all, a second mortgage is a type of home equity loan. But more often than not, home equity loan is used to describe a home equity line of credit, or HELOC. If you want to take advantage of the equity that you have built up in your home, you will need to decide if a HELOC or a true second mortgage is best for you.
Before discussing which might be better for your purposes, let’s look at some of the basics of each. A second mortgage pays out a fixed sum of money to be repaid on a set schedule, like your initial mortgage. Unlike refinancing, the second mortgage does not supersede the first mortgage. Second mortgages are usually 15- to 30-year loans with a fixed rate of interest. Like the initial loan, the rate of interest and points (if any) will be based on your credit history, the price of the home, and the current interest rate. While the interest rate on a second mortgage may be a little higher, the fees are generally lower. Should You Pay Points?
A HELOC, however, is similar to a credit card, and it may even include a credit card to make purchases. Like credit cards, interest is charged, and the amount you can borrow is based on your creditworthiness.
To determine the limit of your HELOC, lenders will look at the appraised value of your home and start their calculations at 75 percent of that value. They then subtract the outstanding balance owed on the mortgage. If your home was appraised at $200,000, the lender would typically look at a maximum of $150,000 or 75 percent. If you had paid off $100,000 of your $180,000 loan, the lender would then deduct the remaining $80,000, which would mean you would have a maximum of $70,000 available on a HELOC if you had a very good credit history. Learn how to Evaluate Your Creditworthiness.
Your current financial needs will help determine which type of loan is right for you. If you need money for a one-time expense, such as building a new deck or paying for a wedding, you would probably opt for the fixed-rate second mortgage.
But if you forecast a recurring need for extra money, such as tuition payments, you may prefer a HELOC. A line of credit allows you to borrow when you need the money and, if you pay back the amounts you borrow quickly, you can save money over a second mortgage. You also need to consider your spending habits. If having another credit card in your wallet would tempt you to spend more often, then you are not a good candidate for a HELOC.
Once you make an initial determination about which loan might be right for you, you will need to discuss the details with your lender. While second mortgages usually operate in the same manner as your initial mortgage, lines of credit are different. Because they feature monthly payments, you will need to review the fine print carefully.
There is no shortage of lenders and offers for loans and lines of credit. Consider your needs, then shop around for a lender you can trust.