"Home equity loan" is the common name given by banks to a second mortgage. This type of loan offers an opportunity for homeowners to get relatively low-cost financing for major purchases like home repairs or college. Home equity lines of credit can also be used for significant expenditures, but you withdraw only the funds you need. To distinguish among equity loans and second home loans, weigh their financial attractiveness against their risks.
When you buy a house and put money down, you immediately have equity in the home. On a conventional loan, a 20 percent down payment on the purchase price is standard. For instance, if you put $40,000 down on a $200,000 property, you have $40,000 in home equity after the close. As you make mortgage payments of principal and interest, your equity increases because your principal loan balance drops. An equity loan is money loaned to you based on the equity value of your home. Common uses include home improvement or renovations, college education or other big ticket purchases.
Any loan staked to your property as collateral has some financial advantages over unsecured loans. The lender has less to lose since you allow the lien against your property. On an unsecured personal loan, the lender takes a risk based on your credit history and income. Since the second mortgage lender has claim on your property, you get a better interest rate. Often, equity loan rates are 3 to 5 percent lower than what you can get on a personal loan. Interest on equity financing is also normally tax deductible.
The term "second mortgage" tends to carry a negative connotation among homeowners. People sometimes view it as a move of desperation that exposes your home to loss to get quick cash. Banks and lenders market these loans as home equity loans to emphasize the positive spin that you're actually borrowing money based on your ownership in your home. Still, further leveraging your property with another secured loan does increase your potential for foreclosure. Plus, you add monthly loan installments on top of your first mortgage payments, which makes for a tighter budget.
The HELOC Option
An alternative to a second mortgage loan is a home equity line of credit, or HELOC. Though a line of credit isn't typically referred to as a second mortgage, it is very similar to the equity loan with one major distinction. Rather than borrowing a fixed amount, the lender gives you access to a credit line. For instance, a HELOC with a $50,000 limit means you can borrow up to that amount. This gives you more flexibility when you don't know how much you need to spend.
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