HELOC vs. second mortgage: what's the difference?
A Home Equity Line of Credit (HELOC) is a type of loan that’s based on the amount of equity you have in your home. HELOCs are offered by credit unions, banks, and some online lenders.
According to the Consumer Financial Protection Bureau, a second mortgage or junior lien is a loan you take out using your house as collateral while you still have another loan secured by your house. Home equity loans and home equity lines of credit (HELOCs) are common examples of second mortgages.
At Credit Union of Southern California (CU SoCal), we make it easy to open a HELOC account!
Call 866.287.6225 today to schedule a no-obligation consultation and learn about our mortgages, home equity lines of credit, auto loans, personal loans, checking and savings accounts, and other banking products. As a full-service financial institution, we look forward to helping you with all your banking needs.
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What is equity in a home?
Equity is the amount of the home you own. A homeowner who doesn’t have a mortgage loan has 100% equity in their home. If you have a mortgage, you can calculate your equity by subtracting the mortgage amount from the appraised or market value amount. For example: Appraised value $600,000 – Amount owed on mortgage $250,000 = $350,000 Equity. Divide the equity ($350,000) by the home value ($600,000), which is 58% equity. Most lenders require 15-20% equity for a HELOC.
What's a HELOC?
A HELOC can be provided by a lender, such as a credit union or bank. Like a credit card, a HELOC has a credit limit and a variable interest rate. Unlike a credit card, a HELOC is secured by the equity in a home and typically has a lower interest rate than credit cards.
HELOCs can be used for any type of purchase. Some common uses for a HELOC include home renovations, buying a second home or investment rental property, paying for college tuition, and paying-off high interest debt.
A HELOC is a “secured loan,” meaning that lenders require that the borrower put up security or collateral (in this case the borrower’s home) to secure the loan. Because your home is used as collateral, if you default on the loan, the lender can take possession of your home. This is one of the cons of HELOC loans.
What's a second mortgage?
A second mortgage is a type of loan that is based on the equity in your home. A HELOC and a home equity loan are both types of second mortgages. As the name implies, a second mortgage is in addition to your first mortgage, and you will still make payments on your first mortgage.
Is a HELOC considered a second mortgage?
Yes, a HELOC is a type of second mortgage. Any loan based on the equity on your home is considered a lien, meaning that if the loan is not repaid, the lender can foreclose on your home to recover the value of the money you owe.
HELOC vs. Home Equity Loan: which is better?
Advantages of HELOCs
Low APR: While most HELOCs come with an adjustable interest rate, the Annual Percentage Rate (APR) on a HELOC is typically lower than the interest rate charged by credit cards on purchases and cash advances.
Interest may be tax deductible: According to the
IRS, interest paid on home equity loans and lines of credit is only deductible when you use the proceeds to buy, build, or substantially improve your home that secures the loan. For example, interest on a home equity loan used to build an addition to an existing home is typically deductible, while interest on the same loan used to pay personal living expenses, such as credit card debts, is not.
Get more information from the IRS.
Borrow only what you need: Because this loan is a line of credit, you can take out money as you need it, and you will only pay interest on the amount you borrow.
Flexible repayment options: All HELOCS have a “Draw Period” (typically 10 years) and a “repayment period” (typically up to 20 years). During the draw period, you can borrow as much of the funds as you need. Depending on the lender, payments made during the draw period may be “interest only,” meaning you aren’t repaying the loan principal. Some lenders will allow payments toward the principal during the draw period. Be sure to ask the lender about repayment terms.
Raise your credit score: Making on-time loan payments will boost your credit score. Adding a HELOC to your credit mix can boost your
FICO score in two ways: by adding to your credit history (which accounts for 35% of your credit score), and adding to your credit mix (which accounts for 10% of your credit score).
No pre-payment penalty. Most financial institutions do not charge a pre-payment penalty if you pay off your HELOC.
Disadvantages of HELOCs
Your home will be used as collateral: If you default on the loan, the lender can take possession of the house through foreclosure, and you could lose your home. Failure to make on-time monthly payments will hurt your credit score.
Variable interest rate: HELOCs often come with a low promotional rate as well as a variable rate that can increase over time. A variable interest rate means the payment owed will be different each month. If your financial situation worsens during the loan period, you could end up owing more than you are able to pay.
Overspending: Because the money is available, many people will borrow from it freely and run the risk of using more funds than originally planned. The draw period’s interest-only payments make repayment appear manageable, but eventually the principal amount will need to be paid back.
Reduced equity in your home: Using your home as collateral means you have less equity. This could affect your ability to get approved for other loans while you have an open HELOC.
HELOC vs. home equity loan?
Each homeowner’s circumstances are unique and the line of credit or loan you choose should work for your budget and financial goals.
Advantages of home equity loans
Lump sum. If you need a large sum money all at once to make a large purchase or do a home renovation or remodel project, home equity loan is very convenient to have. For example, if you’re having a swimming pool installed and have a $50,000 estimate from your contractor, a home equity loan can cover the cost.
Fixed interest rates. A fixed interest rate on a loan means payment predictability. This is important for budgeting your monthly expenses and payments.
Interest may be tax deductible. According to the
IRS, interest paid on home equity loans and lines of credit is deductible when you use the proceeds to buy, build, or substantially improve your home that secures the loan.
Disadvantages of home equity loans
Higher interest rate HELOCs. Home equity loans tend to have a higher interest rate than home equity lines of credit. This means you may pay more interest over the life of the loan for the same amount borrowed.
Your home will be used as collateral. A loan that’s based on the equity in your home means that if you fail to make your monthly payments, not only will your credit score decline, but you could also lose your home if you default on the loan.
Closing costs. A home equity loan is essentially a second mortgage, and you’ll pay closing costs for the loan approval process. Expect to pay 2% to 5% of the loan amount. To avoid high closing costs, consider getting a loan from the financial institution where you already do your banking. You may be offered lower or waived fees.
Pre-payment penalty. Some lenders charge a pre-payment penalty to borrowers who repay the loan too soon after being approved. Before you sign for the loan, ask lenders to provide you with a copy of their loan agreement.
Two mortgage payments. You already have a mortgage, and a home equity loan is essentially a second mortgage. Be sure you can afford to make two monthly payments in full before signing for the new loan.
How to choose between a HELOC and a home equity loan
When considering your borrowing options, look at factors such as the amount of money you really need, interest rate charged, and your ability to pay back the loan. Home equity loans differ from HELOCs in their interest rates; the former has a fixed rate while the latter has a variable rate. Having a loan with a fixed interest rate means there are no payment surprises and the amount you pay each month will be the same until the loan is paid off. A HELOC with a variable credit rate means your payments may increase or decrease month-to-month.
A home equity loan lets you repay the loan in 5-10 years. On the other hand, a HELOC provides revolving credit that can be paid in 10-20 years.
Alternatives to HELOCs and home equity loans
If you do not qualify for a HELOC or home equity loan, there are several other types of loans and credit options you may qualify for.
Cash-out refinance
If you have a mortgage on your home, refinancing your current mortgage to a new mortgage loan provides the opportunity to get cash-out at closing. This means borrowing more than what you owe on your current mortgage and getting a cash disbursement of the extra funds at closing. You can use the cash any way you choose.
Home improvement loans
These loans are specifically for home renovation and remodeling projects and can be in the form of an unsecured loan or secured loan. An unsecured loan can be applied for based on your credit score and you don’t need security or collateral to be approved. A secured loan requires the borrower to put up collateral or security, such as your home, to qualify.
Personal Loans
Credit unions and banks offer a wide variety of
secured and unsecured personal loans, to meet a wide variety of borrowing needs. You’ll find variable and fixed rate
personal loan options.
Family Loans
You may have family members that are willing to loan you the money you need; however, this type of loan can damage the relationship if you fail to pay back the money. If you borrow money from a family member, always put in writing what the repayment terms will be.
0% APR Credit Cards
There are many credit cards that offer a promotional 0% APR (annual percentage rate) for a fixed period, usually 12 months. After the promotional rate expires, there will be a new higher rate applied to the outstanding balance, so be sure you know what the post-promotional rate will be. This option can be good if you need extra money in the short term.
CD Loan
A CD is a Certificate of Deposit — a type of savings account offered by credit unions and banks. This type of loan uses your CD account as collateral. The lender will add a small percentage interest fee to the CD’s APY (annual percentage yield) to come up with the amount you will be charged to borrow money using your CD as collateral.
FAQs
What is the best way to finance a second home?
This depends on your financial situation, the price of the property, and how large of a loan you can qualify for. Speak to an account representative about your options.
How much can you borrow on your second mortgage?
The amount you can borrow will be based on the equity in your home and your credit score.
Can I use a refinance to pay off a second mortgage?
Yes, when you refinance your primary mortgage, you can apply for additional funds to pay off your second mortgage, so that you will have just one mortgage as a result.
Is a HELOC calculated into your debt-to-income ratio?
Debt-To-Income (DTI) Ratio is your total monthly expenses divided by your total monthly income before taxes. Lenders want to know if you’ll have the funds to repay any loan you apply for, so yes, a HELOC calculated into your DTI ratio.
What happens to my mortgage if I get a HELOC?
If you get a HELOC you keep your original mortgage and the HELOC is considered a second mortgage.
Which gets my money faster, a HELOC or a home equity loan?
A HELOC generally can be processed, and funds disbursed quicker than a home equity loan.
Why savvy consumers choose CU SoCal
For over 60 years CU SoCal has been providing financial services, including mortgages, Home Equity Loans, HELOCs, car loans, personal loans, credit cards, and other banking products, to those who live, work, worship, or attend school in Orange County, Los Angeles County, Riverside County, and San Bernardino County.
Please give us a call today at 866.287.6225 today to schedule a no-obligation loan consultation with a CU SoCal Member Services specialist.
Get Started on Your HELOC Today!