Mortgage Vs Home Equity Loan: The Key Differences

Borrowers have several options available for obtaining financing by using their home as collateral for the debt.

Still, by doing so, they put their property at risk of foreclosure and seizure by the lender should they fail to make repayments. 

While both mortgage loans and home equity loans use a property as collateral, they differ in many other aspects.

In this article, we will be comparing the two loans, dissecting how they work, and the risks involved for those borrowers that utilize them. 

In basic terms, a mortgage is taken out specifically to purchase a property, after which equity builds in it.

However, a home equity loan is taken out at a point after purchasing, when equity already exists on a property.

Mortgage Basics

Mention the word mortgage, and most tend to think of a traditional mortgage, whereby you borrow funds from a financial institution such as a bank in order to buy a property.

Banks and online mortgage lenders are unlikely to lend the full value of the house, usually allowing up to 80%.

Homeowners must supply the remaining funds themselves.

There are exceptions, such as FHA mortgages, which allow buyers to put down much less than a 20% payment if they pay mortgage insurance.

Interest rates on mortgages vary and can be fixed-rates (a constant value throughout the term) or variable (subject to change).

Borrowers pay off the loan total plus interest over an agreed period, the most popular being 15 and 30 years. 

Failure to make payments could result in foreclosure and a major credit score hit, where the lender repossesses the home, which they will attempt to sell to recoup the funds originally lent out.

In such situations, this mortgage takes precedence over any subsequent loans linked to the property, such as equity loans.

Home Equity Loans

These are mortgages taken out after a property has been purchased and equity has accumulated.

Traditional mortgages are used to purchase a property, after which equity will follow.

The loan is guaranteed, or secured, by the equity, which equates to the property value minus remaining mortgage payments. 

For example:

• If a homeowner has $200,000 left to pay on a $300,000 property, they have $100,000 in equity

An equity loan is an installment loan that operates the same way as a traditional mortgage.

Lenders have varied criteria on how much equity is required as a percentage of the property value. They use the “loan-to-value” ratio or LTV to calculate a figure.

The calculation is made by:

• Add to the value owed on the house the amount to borrow
• Divide this by the value of the property, giving the LTV ratio
• The greater percentage of the property paid off, the greater the chance of a large loan

A home equity loan can also be referred to as a second mortgage if a property already has an existing mortgage. 

Should a foreclosure occur, the home equity loan lender receives nothing until the initial mortgage lender is paid.

Thus, equity loans are considered a greater risk and attract higher interest rates than mortgages. 

However, an equity loan is not a second mortgage if the borrower has paid off all the initial mortgage.

Here, the lender is a first lien holder and while loans may still attract higher interest rates, closing costs could be lower.

Deducting Taxes

Due to the Tax Cuts & Jobs Act of 2017, one aspect where mortgages and home equity loans are similar is their tax deductibility.

• Prior to the law, home equity loan interest was deductible on up to $100,000 of the debt
• The legislation raised the figure to $1 million for loans taken out prior to December 15th, 2017 or $750,000 for those after that date
• The second figure is now the threshold for all residential debt

There is however a caveat. Prior to the Act, owners could deduct the interest on a line of credit or equity loan irrespective of how funds were used.

Now however, deductions can only be allocated for loans from 2018 to 2025 when funds are used to buy, build, or substantially improve the home attached to the loan.

Funds used to pay off credit card debts for example, would not fit the deduction criteria.

Bottom Line

For homeowners seeking extra funds with a good credit history and low mortgage interest rate, it may be advisable to consider a home equity loan.

However, be aware that there are restrictions on tax deductibility. Accordingly, funds should ideally be used to improve your property. 

If mortgage rates have plummeted since taking out the original mortgage, then refinancing the outstanding mortgage balance might be the best option, as homeowners should be able to secure lower rates.