If you're a homeowner considering taking out a mortgage or a home equity loan or line of credit, whether to pay off existing debt, renovate your home, or make a large purchase, understanding the differences that exist among these products can seem daunting. But some basic background information can help ensure the product you choose will be the right one for your situation.
First Mortgage vs. Second Mortgage
A first mortgage is the first, and usually largest, loan attached to a home. You may acquire a first mortgage when you purchase your home, or you may refinance an existing mortgage into a new first mortgage. A second mortgage is a loan taken out after the first mortgage. You can't have a second mortgage unless you have an existing first mortgage. Second mortgages are often taken out to pay off other unsecured debt, to make large purchases or to pay for major expenditures, such as home improvement projects or college tuition.
Home Equity Loan
A home equity loan is very similar to a second mortgage and some lenders may use the terms interchangeably. The only true difference between the two products is that a home equity loan can be placed on a home on which there is no first mortgage. For instance, if you've paid off your mortgage but want to tap into your home's equity -- that is, your home's value -- without having to apply for a mortgage, you can take out a home equity loan. A second mortgage is taken out when a first mortgage is still in place on the home, and in this case, the two terms do refer to the same loan product.
Home Equity Line of Credit
A home equity line of credit, or HELOC, is a line of credit that is tied to the equity of your home. Your equity is roughly defined as the differences between what's owed on the property and its real market value. Unlike a home equity loan or second mortgage which is paid out in a lump sum, a HELOC allows you to draw money from the line of credit as you need it. Many homeowners choose this option when making large-scale home improvements, when payments for renovations will be made over a long period of time. Many HELOCs have credit cards attached to them. Also, while second mortgages or home equity loans may have either a fixed or adjustable interest rate, HELOCs almost always have an adjustable rate.
Advantages
The main advantage of second mortgages, or home equity loans, and HELOCs is that they all allow you to gain access to the cash value you've built up in your home. The equity may have been built up over time as you've made payments to pay down the loan principal or as a result of an increase in your home's value. Having access to that equity is a great way to make purchases that would otherwise be out of your reach financially or to pay off higher-interest debt.
All of these products also usually have more relaxed qualifying requirements than first mortgages. The HELOC has an added advantage--it does not involve expensive closing costs usually associated with mortgages. Second mortgages and HELOCs also offer tax advantages, and homeowners may generally deduct the interest on the first $100,000 of these loans--usually more if the money is used for home improvements.
Drawbacks
As noted, second mortgages may have significant closing costs associated with them. In most cases, and especially to get the best rates, homeowners must have good credit to qualify for these loans. And for all of these products, the amount of money a homeowner can take out will be limited by the equity in the home. Before applying for these loans, it's a good idea to get a clear idea of the actual value of your home by reviewing recent sales of comparable homes in your neighborhood.
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