How Does a Home Equity Line of Credit Differ From a Second Mortgage?
While both types of loans borrow against the equity in your home, the difference between them is how the loans are paid out and handled by the bank. A home equity loan functions as a second mortgage because the money is distributed in a lump sum. A home equity line of credit, on the other hand, only distributes money on a revolving basis, like a credit card.
Sometimes, home equity lines of credit are also considered a second mortgage because they are a loan that is secured while you already have another loan secured by your house.
How Does a Second Mortgage Work?
A second mortgage or home equity loan uses your home as collateral, just as your primary mortgage does. It allows you to borrow money based on the equity you have in your home, which is the difference between what you owe on your first mortgage and what you could sell your home for today.
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 fixed. Once the loan is paid off, you would have to open up a new loan to borrow against the equity in your home again.
Sometimes, people use a second mortgage as a down payment on the home, avoiding private mortgage insurance (PMI). Used this way, a second mortgage may be termed a "piggyback" loan or a "soft second" mortgage.
As with your primary home loan, if you miss payments on a second mortgage, you could lose your home, so be sure to keep that in mind.
How Does a Home Equity Line of Credit 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.
HELOCs usually have a draw period, such as 10 years, where you can borrow the money. Then there is a repayment period, such as 20 years, where you pay the loan back. You don't owe anything on the loan until you start drawing from it.
Once you have paid off the loan, you can borrow it again without applying for another loan, similar to a credit card. However, if the value of your home drops significantly, your lender may freeze your line of credit. And it is important to keep in mind that if you miss payments on your home equity loan, you can put your home at risk.
Which Option Is Better for Me?
People use both of these types of loans for a variety of reasons: to cover home repairs or renovations, for debt consolidation, even to take a nice vacation. But they should keep in mind that these loans put their homes on the line. Using these kinds of loans to pay off debt is just moving the debt from one loan to another.
If you unexpectedly lose your job or have a serious medical issue, and you can't make your payments, you could lose your house. Additionally, these loans cut into the equity that you have already built on your home.
It is better to avoid using home equity loans for unnecessary or everyday expenses, and it's best to avoid borrowing against your home if you can.
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 line of credit 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 do close home equity lines and they discourage this practice, even if a loan has been in good standing in the past.
Let's say you use your home equity line as an emergency fund. What if you lose your job? You'd need to tap into that home equity line. 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 and losing your house. Plus, these loans often have origination fees and closing costs, not to mention the interest, making them more expensive than cash.
Using a home equity line as an emergency fund is a slippery slope and one that should be avoided. Instead, work on saving up three to six months' worth 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.
Updated by Rachel Morgan Cautero.