Mortgages and home equity loans are both forms of borrowing that use your home as collateral. Mortgages are used by prospective buyers to fund the purchase of a home, whereas home equity loans and home equity lines of credit (HELOC) allow homeowners to borrow against the equity they’ve built up in their homes.
Whether you’re a homeowner or first-time homebuyer, it’s important to understand the key differences between these three loan types before choosing one over the other.
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Comparing Mortgages, Home Equity Loans, and HELOCs
Here’s a breakdown of the most important differences between mortgages, home equity loans and home equity lines of credit.
What Is a Mortgage?
A mortgage is an agreement between you and the lender to finance your purchase of a home by providing you with the bulk of the cash upfront—provided you meet certain requirements. The lender can foreclose on you and take possession of the home if you fail to repay the principal amount borrowed plus interest.
A conventional mortgage is the most common type of mortgage. These are issued by banks, credit unions and other lenders. Conventional mortgages must comply with rules set by Fannie Mae and Freddie Mac, the two most notable government sponsored entities that support the U.S. mortgage system. These rules require you to have:
- A minimum credit score of about 640 to qualify.
- A debt-to-income (DTI) ratio under 43%.
- No major credit report issues, like bankruptcy or foreclosure.
- A minimum down payment of 3%, or 20% if you want to avoid private mortgage insurance (PMI).
In addition to the above rules, all conventional mortgages need to be within the conforming loan limits set by the Federal House Finance Agency (FHFA) every year.
There are also unconventional mortgage options backed by the government. Federal Housing Administration (FHA) loans are issued by approved lenders—and insured by the FHA— to help low-to-moderate-income borrowers buy homes. The Department of Veterans Affairs (VA) and the U.S. Department of Agriculture (USDA) also offer mortgages with lax credit and down payment requirements.
What Is a Home Equity Loan?
Unlike a mortgage, you have to already own a home to apply for a home equity loan. Home equity loans, sometimes called second mortgages, are offered by a variety of mortgage lenders and let you access the equity you have built up in your property.
You’ll usually need good to excellent credit, as well as a stable income and a low DTI ratio to qualify for a home equity loan. You must also have enough equity in your home—typically at least 20%.
This means you can generally borrow up to 80% of your home’s value with a home equity loan, depending on your first mortgage balance, the lender and your financial profile. If you’re approved, you’ll receive a lump sum to use how you wish—for example, to cover large expenses like home improvements or unexpected medical bills.
You’ll be charged a fixed interest rate that doesn’t change during the life of the loan. And you’re expected to pay interest on the entire balance of the loan, even if you don’t use all of it. Keep in mind that a home equity loan is secured by your home, which means the lender could foreclose on your house if you default.
Though some lenders may waive certain loan costs, most charge fees and closing costs. So take the time to compare more than just your monthly payment when shopping around.
What Is a HELOC?
A HELOC is a revolving credit line that you can repeatedly tap and pay off—similar to a credit card. While guidelines vary, you can typically access up to 85% of your home’s equity with a HELOC. However, there are limits to how much you can borrow with a HELOC, no matter how much equity you have. The limit you’re offered will be based on your loan-to-value (LTV) ratio.
A HELOC’s term works a little differently than a home equity loan’s term. Your HELOC is split into a draw period and repayment period. During the draw period, which typically ranges from five to 15 years, you can make withdrawals from your HELOC up to your credit limit and are only required to make minimum interest payments.
Once the draw period ends, you’ll enter your repayment period, which usually ranges from 10 to 20 years. You cannot make any further withdrawals and must pay back whatever amount you borrowed during your draw period, plus interest.
How Do I Decide Between a Home Equity Loan and HELOC?
As a homeowner, deciding between a home equity loan and a HELOC ultimately comes down to your needs. A home equity loan makes sense if you know the exact amount you need and want a structured loan—similar to your first mortgage—with a maturity date and fixed monthly payments.
For a more flexible financing option, or if it’s not clear how much money you will need, a HELOC could work better.
It’s important to note that HELOCs are variable-rate loans, meaning the interest rate you receive at the start can change throughout the life of the loan. However, depending on your lender, you may be able to convert the loan to a fixed-rate HELOC during the repayment period.
Reverse Mortgage vs. Home Equity Loan
Another way to access your equity is through a reverse mortgage. These are more complex than home equity loans and traditional mortgages, and they are intended only for elderly homeowners (at least 62 years old) who have built up significant equity in their homes.
With a reverse mortgage, you receive payments from your lender, which draws from the equity in your home. Interest and fees are added to the reverse mortgage balance each month, meaning how much you owe will go up over time. As your loan balance increases, the equity you have in the property declines.
Unlike a home equity loan or traditional mortgage, you don’t make monthly payments on a reverse mortgage, and there are generally more relaxed credit requirements. However, you’ll need to continue paying property taxes, homeowners insurance and keep your house in good condition. A reverse mortgage is paid off once you die or move out, typically by selling the home.
While reverse mortgages can be a good way to borrow against your equity, they come with notable risks. For instance, if you can’t keep up with your property taxes or homeowners insurance payments, or you fail to keep your home in good condition, your loan could go into default.
Mortgage vs. Home Equity Loan vs. HELOC
If you are a homebuyer in need of financing to purchase your dream home or an investment property, then a mortgage is likely the option for you.
However, if you want to raise funds for much-needed home improvements—perhaps before putting it on the market—then a home equity loan or HELOC could be the way to go. A HELOC may also make sense if you want access to emergency funds, without knowing exactly how much you will need and when.
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