How Does a Home Equity Loan Differ From a Second Mortgage?
Since both a home equity line of credit and a second mortgage are both attached to your home, many people don't know the difference between the two. While both are essentially additional mortgages on your home, the difference between them is how the loans are paid out and handled by the bank. Read on to learn the differences between a home equity loan and a second mortgage.
How Does a Home Equity Line Work?
A home equity line of credit (HELOC) is a revolving line of credit. The bank opens the credit line and the equity in your home guarantees the loan. A revolving line of credit means that you can borrow up to a certain amount and make monthly payments. The payments are determined by how much you currently owe on the loan.
Once you have paid off the loan, you can borrow it again without applying for another loan, similar to a credit card. It is important to keep in mind that if you miss payments on your home equity loan, you can put your home at risk. This is why you should avoid using it to pay off your credit cards or other debt.
How Does a Second Mortgage Work?
A second mortgage is also a loan that uses your home as collateral. It operates differently than a home equity line of credit, though.
A second mortgage is paid out in one lump sum at the beginning of the loan. The payment amount and the term (length) of the loan are already set. Once the loan is paid off, you would have to open up a new loan to borrow against the equity in your home again.
Many people will use a second mortgage as a down payment on the home to avoid private mortgage insurance (PMI). They may also take out a second mortgage to cover home repairs or renovations, or even to pay off debt. As with a home equity loan, if you miss payments on a second mortgage, you can lose your home, so be sure to keep that in mind.
Which Option Is Better for Me?
People use both of these types of loans for a variety of reasons. One common reason is debt consolidation. However, it is risky to move unsecured debt, such as credit card debt, to a secured loan. It puts your house at risk if you are unable to make payments for any reason, like if you unexpectedly lose your job or have a serious medical issue. Additionally, it cuts into the equity that you have already built on your home.
People may also take out a home equity loan to pay for home repairs or to go on a vacation. It is better to avoid using home equity loans for these types of expenses and is best to avoid borrowing against your home.
Where Do I Put These Loans in My Debt Payment Plan?
In a debt payment plan, it is important to put a second mortgage or a home equity line in with the rest of your consumer debt. It should be paid off before you start investing seriously because the interest rates on these types of loans are generally higher than those for most first mortgages.
The second mortgage or home equity loan may be the last item on your debt payment plan or may come before your student loans, depending on the interest rate of each loan.
Should I Use a Home Equity Loan as an Emergency Fund?
In the past, many people used home equity lines as emergency funds. However, banks are beginning to close home equity lines and discourage this practice, even if they have been in good standing in the past.
Instead of relying on the equity in your home as an emergency fund, you should work on saving between three to six months of expenses to cover any unexpected financial emergencies. This puts the control of your financial stability back into your hands – and doesn't put your home at risk or undercut the equity you've been working so hard to build.
Let's say you use your home equity line as an emergency fund. What if you lose your job? You'd need to dip into that emergency fund, right? But if you don't find a new job quickly enough, you'll have a hard time managing both your mortgage payment and your home equity loan payment, in addition to all your other monthly expenses.
As the balance of the loan grows, so will your payment, which increases the risks of defaulting on the loan. Using a home equity line as an emergency fund is a slippery slope and one that should be avoided at all costs
Updated by Rachel Morgan Cautero.