Mortgages vs Home Equity Loans

Mortgages vs Home Equity Loans

If you are buying a home, there is a good chance that you will need to get a loan in order to pay for it upfront or make improvements to it later. Did you know that you have a choice of which type of loan you can get? Depending on your needs and situation, one may be better than another.

 

The two main types of borrowing methods for property, mortgages and home equity loans, both involve pledging the home or property as collateral for the owed debt. This means that the lender can eventually take the home if the payments cannot be made. While this is one similarity between the two loan types, there are some important differences between the two – let’s look at those differences below.

 

Mortgages

 

A traditional mortgage is a loan where a financial institution, such as a bank or credit union, lends money to a borrower to help them purchase a property. In most cases, the lender lends as much as 80% of the purchase price of the home, and the borrower pays the remaining amount as a down payment.

 

While 20% down payments are common, it is possible to pay 15%, 10%, or even 5% of the purchase price as a down payment instead. These types of mortgages generally include mortgage insurance payments which make them a little more expensive to repay.

 

Mortgage interest rates come in two forms: fixed and variable. Fixed rates stay the same throughout the entire term of the mortgage, while variable rates can change (often once or twice a year). The borrower is responsible to pay back their loan plus interest over a fixed amount of time, commonly between 15 and 30 years. As we mentioned above, if the borrower falls behind on their repayment, the lender can seize the property in a process called foreclosure. The lender can then resell the home in order to gain back the money that they lent the borrower. If there is more than one loan on the home, the original lender is always paid off in full first.

 

In order to qualify for a mortgage, you’ll need to provide some info to your lender such as your income, existing loans, expenses, assets, credit report, etc. How much you qualify for depends on your debt to income ratio, and this will likely affect the price of home you can afford to buy. For this reason, it’s always a good idea to get pre-approved from a mortgage broker you begin looking for a new home.

 

Home Equity Loans

 

Technically, a home equity loan is also considered to be a mortgage, but there are some key differences between the two. One of the main differences is that usually a home equity loan is taken out after purchasing and accumulating equity on your property. While a mortgage is the loan that allows the buyer to purchase the property in the first place, a home equity loan allows a homeowner to take out some of the value of their property and use it for other needs such as renovations. A home equity loan is repaid over a fixed amount of time just like a traditional mortgage.

 

A home equity loan is guaranteed by the homeowner’s equity – which is the difference between the property’s value and the existing mortgage balance. For example, if your home is worth $400,000 and you owe $175,000, you have $225,000 in equity. If you have good credit and fully qualify for the loan, you can take out an additional loan using that equity as collateral. Depending on the lender and the borrower’s credit rating, some lenders will offer to lend different percentages of the home’s equity.

 

Since a home equity loan is often taken on with an existing traditional mortgage in place, they are often referred to as a second mortgage. As we mentioned above, in a foreclosure situation the first lender is always paid in full first, which means that the home equity loan lender’s risk is greater. Because of this, home equity loans often have higher interest rates than a traditional mortgage.

 

But not all home equity loans are second mortgages! If a homeowner is free and clear (meaning they have paid off their traditional mortgage and fully own their home) and decides to take out a home equity loan, this will be the only loan and therefore the lender will be considered the first lender. While these loans may still have slightly higher interest rates, the conditions might be slightly more lenient – for example an appraisal may be the only requirement to complete the loan.

 

LTV Ratio

 

Lenders commonly use the loan-to-value (LTV) ratio to figure out how much they are willing to lend. This amount is calculated using by adding together the loan amount requested and the amount still owed on the house, and then dividing that number by the appraised value of the property. If a borrower has paid down a large amount of their mortgage or if the home has significantly raised in value, there is a potential for a sizable loan.

 

The Bottom Line

 

So, what are the key takeaways? Well, if you need extra funds and already have a low interest rate on your current mortgage, consider using a home equity loan to borrow the extra cash. On the flip side, if mortgage interest rates have dropped since you signed your existing mortgage agreement (or if you need the money for something unrelated to your home), maybe consider refinancing your traditional mortgage instead.

 

If you are looking for more advice and guidance on which type of loan is best for you, get in touch! Our team is always happy to help you find and secure the best loan option for you.