A second mortgage can be a low-cost option for homeowners in need of cash, but they have 2 options to choose from

Shutterstock

Home equity loans and HELOCs — both of which are commonly called a second mortgage — allow you to borrow against the value of your home.
Many people use home equity products to pay for remodeling projects or to consolidate high interest debts.
Home equity loans come with a fixed interest rate, fixed monthly payment, and fixed repayment timeline. This makes them a predictable option for borrowers who don’t like surprises.
HELOCs, on the other hand, come with variable rates and let you borrow as you need. In fact, they function a lot like a credit card, the main difference being that you’re using your home as collateral.

Even if you have no desire to prolong your mortgage payment or add to the debts you have, there are plenty of good reasons to borrow against the equity in your home — commonly called a second mortgage.

Interest rates are typically much lower than other borrowing options, for example, which means you could be a lot better off if your alternatives are a personal loan or a credit card. Since the loans behind a second mortgage, HELOCs and home equity loans, use your home as collateral, they may also be easier to qualify for.

Another benefit of home equity loans and HELOCs is the fact that you can use the money however you want. Sure, you can use your loan proceeds to remodel your kitchen or add on a new family room, but you can also repair a leaky roof or consolidate high interest credit card debt. Heck, you could use your home equity proceeds to book a luxury vacation to the Maldives if you want (although you definitely shouldn’t).

Home equity loans vs. HELOCs

But, should you get a home equity loan or a HELOC instead? This is a question many homeowners ask as they try to figure out the difference — and which option might work best.

While both home equity products let you borrow against the equity you have in your home, they don’t work in the same way. The key to knowing which one is best for your needs is deciphering the details and understanding the pros and cons of each.

All about home equity loans

Home equity loans let you borrow against the equity in your home and receive your funds in a single lump sum. Loan amounts are typically limited by your loan-to-value ratio, a calculation that takes into account your home value minus your existing mortgage and limits your loan to about 80% to 90% of that balance — if you qualify.

Like personal loans, home equity loans come with a fixed interest rate and fixed repayment term. Because of this, you’ll also get a fixed monthly payment that doesn’t change during the life of the loan. In that sense, home equity loans are extremely predictable; you know how much you’re borrowing, how long you’ll pay it back, and exactly how much you’ll owe each month.

You’ll want to find out upfront whether your lender charges a prepayment penalty, in case you want to pay back the loan ahead of schedule, and how much you’ll be expected to pay in fees and closing costs. Different lenders have different fee structures — some have very low fees — so you’ll want to compare your options.

Pros of home equity loans:

Fixed monthly payment, loan term, and interest rate

Cons of home equity loans:

You’re using your home as collateral, so you risk foreclosure if you don’t repay
Some home equity loans have fees, including an origination fee and closing fees
You are required to figure out how much you want to borrow up front

Looking for a loan? Consider these offers from our partners:

All about HELOCs

Where home equity loans work a lot like a personal loan, home equity lines of credit, or HELOCs, work similarly to a credit card. Instead of giving you a lump sum, a HELOC is a line of credit you can borrow against when you need the money. As such, you will only repay amounts of money you borrow in the end.

Like home equity loans, HELOCs usually limit your borrowing ability to up to 85% of your home’s value, and may or may not include fees depending on the lender. They typically come with a variable interest rate that is based on an index, although some lenders allow customers to convert these to fixed rates. They also tend to have a borrowing period (usually 10 years) and a repayment period (usually 20 years), and you can only take money out during the initial borrowing period.

Since your payment is based on how much you borrow and your interest rate is variable, however, your monthly payment amount may be hard to predict — and it could even fluctuate over time.

Pros of HELOCs:

Only borrow amounts you need instead of a lump sum
Your variable rate could remain low since it’s based on an index
Many HELOCs come with no fees or low fees

Cons of HELOCs:

You’re using your home as collateral, so you risk foreclosure if you don’t repay
Some HELOCs require a large balloon payment or lump sum at the end
Some HELOCs have fees, including an origination fee and closing fees
Your monthly payment can vary — and even rise — based on your interest rate and how much you borrow

Home equity loan or HELOC? Only you can decide

While the new tax law passed in 2017 cast some doubt over whether consumers could deduct interest paid on home equity products on their taxes, the Internal Revenue Service (IRS) cleared that up last year. In a press release, it noted that home equity interest is still deductible provided the funds are "used to buy, build or substantially improve the taxpayer’s home that secures the loan." In other words, you can deduct the interest from a HELOC or home equity loan if you’re using the funds to improve your property in some way, but not if you’re using them for a Caribbean cruise.

You must be in a position to deduct home equity interest for this to matter. Remember that the mortgage interest deduction is only applicable if you itemize on your taxes, and fewer people will do that this year since the standard deduction has been raised to $24,000 for married couples filing jointly and $12,000 for individuals.

With that detail out of the way, it shouldn’t be too hard to decide between a HELOC or a home equity loan. If you want a fixed monthly interest rate and a fixed payment and don’t mind borrowing a lump sum, get a home equity loan. If you don’t mind a variable interest rate and want to borrow as you go, on the other hand, get a HELOC. Just remember that your monthly payment might fluctuate as rates rise or you borrow more.

Both options tend to be inexpensive and they both come with lower interest rates than you’ll find elsewhere. Most importantly, they will both help you access your home equity and achieve your goals — whatever they are.

Source: Business Insider – holly@clubthrifty.com (Holly Johnson)