Home equity mortgage can be a confusing term. Is it a second mortgage or a home equity loan? A true home equity mortgage is just a home equity loan, sometimes shortened to HELOC. There are distinct differences between a home equity mortgage and a second mortgage.
Second Mortgage
A second mortgage is a loan that places a second lien on your home and provides the borrower with a lump sum payment. This can be compared to the one-time payment made with the first mortgage when buying a house. A second mortgage is structured similarly to a first mortgage and can have fixed or variable rates.
Home Equity Line Of Credit
Home equity mortgages, on the other hand, are a line of credit. The amount of credit extended is based on the value of the equity in your home. These loans always have variable rates. They are also more flexible for homeowners because they can borrow just what they need when they need it. For example, if you knew your home needed renovations to the kitchen, bathroom and basement, you could tackle one project at a time. With a traditional second mortgage, you would have to take the entire amount at once and pay interest from day one.
Home Equity or Second Mortgage?
Deciding which avenue is right for you will depend on your situation. Some people take out a second mortgage simply to keep the loan to value ratio down on the first mortgage and avoid payment PMI. This is a useful tool when the PMI premium exceeds the interest payments on the second loan.
But consider this couple’s question:
"We need $40,000 to redo my kitchen, bathroom and basement. We are doing the work ourselves and trying to stay in the house we renovate by sticking to one project at a time. Should we take out a home equity mortgage or try for a second mortgage?”
This couple is much better off going with the home equity mortgage. They can access the line of credit for the kitchen and pay interest on only that withdrawal. Some lines even come with a credit card that lets them make small purchase just like on a regular credit card at no additional charge. Otherwise, they would have to take out a lump sum and hold onto the money as they renovate. Even if they placed the money in short term investments, they would be unlikely to yield enough return on the money to pay the cost of interest on the full loan.
If this same couple was performing the renovations all at one time, they might prefer a second mortgage, but only if there was an interest savings over the home equity mortgage.
This same couple might ask, “Would we be better off with mortgage refinance?” The answer to that question is a little more complicated. It will depend on several factors. For instance, if the home were worth $200,000 with a loan of $150,000, the refinance would put the loan to value ratio above 80%. The bank would then require the couple to pay Private Mortgage Insurance (PMI). This is probably not the optimal scenario.
But say the same loan is taken on a home valued at $300,000 and PMI will not come into effect? Then you need to consider many complicated factors that are best discussed with a loan professional. In many cases, the home equity mortgage and second mortgage will be better options, so long as they are taken out for short terms of 10 or 15 years.
Finally, the two may want to know if they should instead borrow from their 401K plans for the renovation funds. The logic behind the question is that the couple would realize significant tax savings when paying interest on a home equity mortgage, but not on the money they pay back to their 401K plans.
The simple answer is that you should borrow from your 401K as a last resort. The full answer is that you should take the action that results in the greatest cost savings. On a loan, that savings is primarily in the interest rate.
Home Equity Savings
Comparing apples to apples, the home equity mortgage wins easily. If both options had the same interest rate, the average couple would see a savings of one or two percentage points after tax. Add to that the interest they would be losing with the money taken out of the 401K and the savings is even more obvious. Borrowing from your 401K is also risky. If your employment should end for any reason, whether through your decision or because the company terminates, the 401K becomes due in full.
The many advantages of home equity mortgages explain their popularity. For most people it makes good financial sense to choose the equity mortgage over the second mortgage or the 401K.