Home Equity v. Mortgage Loan: Risks and Rewards

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When choosing between a home equity or mortgage loan, weigh the risks and rewards of each against your specific needs for borrowing funds, your ability to repay and your personal spending habits. A home equity and mortgage loan both have pros and cons depending on your circumstances.

How a Home Equity and Mortgage Loan Work
For most, a home is the largest asset owned and the best source of securing debt to borrow for specific needs. Most homes have equity in them, which is the difference between the home’s current market value and the amount owed on the home. For example, if you pay $200,000 for your home and have a $160,000 mortgage, you have $40,000 in equity. Equity increases if the market value of your home rises and as you pay down your mortgage.

Both a second mortgage and a home equity loan is secured by that equity. Typically, a lender will allow you to borrow an agreed percentage of the equity, which will vary with your credit rating and current market conditions.

Rewards of a Second Mortgage
A second mortgage looks much like your original home loan. It has a fixed interest rate, fixed number of years over which it must be paid back and is for a fixed purpose. A second home mortgage is a typical loan used to add on to a home, buy a second home or make a specific major purchase. With the fixed terms, you know exactly what you owe and when.

Risks of a Second Mortgage
A mortgage loan like a home equity loan has risks associated with it as well. You have increased your total debt and therefore limited your flexibility to borrow more if a special need arises. If interest rates decline, as often happens in a deteriorating market, you are locked in unless you refinance, which can be costly. Closing costs are higher with a mortgage loan than a home equity loan because you often must pay points to get an interest rate for which you can qualify.

Rewards of a Home Equity Loan
The typical home equity loan is actually a home equity line of credit. This means a lender offers you the ability to draw money out of your home when you need it and whatever you need it for, so long as the amount does not exceed the agreed percentage of your equity. If the market value of your home rises, you have a larger “pot” of money from which to draw. The home equity loan offers more flexibility than a mortgage loan because you can use it for any purpose. For example, if you have children in college with tuition payments of varying size due at varying intervals, a home equity not a mortgage loan allows you to take out what money you need when you need it.

Risks of a Home Equity Loan
With a home equity instead of a mortgage loan you do not have a fixed interest rate. Each time you borrow with your home equity loan, it will be at a rate pegged to agreed market benchmarks. This means your borrowing can be more expensive than anticipated at the time you need the money.