Buying a home is one of the most significant investments you can make. For most homebuyers, that large of a purchase requires financing in the form of a mortgage. But once you have made your purchase, your mortgage payments start working for you as you build equity in your home. Home equity can be leveraged by taking out a home equity loan, also known as a second mortgage.

These two financial tools are very similar, but there are differences, especially in repayment terms. Let’s find out the similarities and differences.

KEY TAKEAWAYS

  • Home equity loans and mortgages both use property as collateral for a secured loan.
  • Home equity loans are typically fixed interest rates over a period of five to 30 years.
  • Mortgages can be fixed rates or adjustable rates.

What Is a Mortgage?

A mortgage is an installment loan used to purchase a home. There are several different types of mortgages, including conventional loans backed by banks, and loans backed by the Federal Housing Administration (FHA), the U.S. Department of Veterans Affairs (VA), and the U.S. Department of Agriculture (USDA).

Mortgage loans can have either fixed interest rates or adjustable rates. Adjustable-rate mortgages (ARMs) adjust their rates on a set schedule. For example, a 5/1 ARM offers a fixed rate for the first five years. After that, the rate will adjust yearly until the loan is paid. There are many different types of ARMs, so make sure you understand the terms of your agreement.1

 

You must have at least 20% equity in your home to be approved for a home equity loan.2 If you have an interest-only loan, your first several years may not build any equity to borrow against in the future. Equity can still be built by increasing the value of your home, either through improvements or market movement.

What Is a Home Equity Loan?

A home equity loan is a loan secured by the equity built in your home, either by making mortgage payments or by increasing the value of your home. Home equity loans are often called second mortgages because they function in a very similar way. They are both installment loans secured by property, and in the event of nonpayment, the lender will seize the property to repay the loan.3

As opposed to a mortgage, a home equity loan is paid out in a lump sum of cash.4 The funds can then be used to pay for anything. Some common uses are for home improvements, paying down high-interest debt, or funding a vacation, wedding, or education.

How Are Home Equity Loans and Mortgages Similar?

Both home equity loans and mortgages are repaid on a fixed schedule. The most common repayment periods for mortgages are 15 and 30 years, but some lenders offer 10- and 20-year terms as well.1

Home equity loans can range from five to 30 years of fixed payments.2 It’s fairly uncommon to find adjustable-rate home equity loans.

Both types of loans can also incur closing costs such as appraisals, document fees, notary fees, and origination fees.5 Some lenders will waive some fees for home equity loans to make it more attractive for borrowers.

How Are Home Equity Loans and Mortgages Different?

While home equity loans and mortgages are very similar, there are key differences. The first is in the interest rate. Home equity loans tend to have a slightly higher interest rate than a primary mortgage. Since home equity loans are considered second mortgages, if you fail to make your payments, the home could go into foreclosure to satisfy the debt. If the lender sells the home, it will use the proceeds to pay the primary mortgage first and then use any excess to pay the home equity loan. As a safeguard, they charge more interest to offset any potential loss.

There is also more variety of repayment plans for mortgages. Although the most common payment term involves payments that include money toward your principal and interest, there are also interest-only loans. Interest-only loans are structured as ARMs, and borrowers pay only interest for a set period of time before payments transition to the more traditional principal and interest format.

 

Beware of interest-only loans if you’re interested in building equity for a future home equity loan. During the interest-only period, they do not build equity.

Can I have a home equity loan if my mortgage is paid off?

Yes. A home equity loan is based only on your equity, not whether you have a mortgage. If you own your property outright, you have 100% equity. That said, you are still limited to borrowing only 80% of your home’s equity.3

How much equity do I need for a home equity loan?

Lenders prefer that you have at least 20% equity in your home to grant you a home equity loan.2 You can build equity by either making payments or increasing the value of your home. If the housing market rises, that may also increase your equity.

Is there a minimum amount you can borrow on a home equity loan?

This will vary from lender to lender, but most lenders prefer to set a minimum loan amount of $10,000.6 Since home equity loans often involve closing costs and costs for appraisals, it’s wise to make sure that the amount you borrow is worth the fees. If you want to use your home equity for a smaller loan or anticipate requiring small sums over time, you might consider a home equity line of credit (HELOC) instead.

The Bottom Line

Mortgages and home equity loans have very similar repayment terms. Watch out for adjustable-rate mortgages (ARMs)—your costs may fluctuate in volatile markets, and if you choose an interest-only loan, you may miss out on valuable equity-building time. Home equity loans offer flexibility for big purchases and can be figured into your monthly budget in the same way that your mortgage does. Choose a term and payment that fits your budget to avoid defaulting on your commitments and losing your home.