Why Home-Equity Loans And Mortgages Are Not The Same
Home-equity loans and mortgages are both loans in which the homeowner pledges their property as collateral. That pledge gives the lender the right to take over the property if the homeowner failed to repay the loan based on the agreement terms. While this is one of the key similarities of both loan types, homeowners must be aware that both loans are different. Once you understand how they are different, you’ll know exactly what you’re committing yourself to when borrowing against your home’s value.
How a mortgage works
A mortgage is a straightforward process. A lender or a bank lends a borrower some amount of money to buy a home. In many instances, the bank lends up to eighty percent of the home’s appraised value or the buying price. For instance, a potential homeowner looking to buy a home of $300,000 is eligible for a loan that is up to $240,000. Such buyer has to come up with the remaining $60,000 on their own.
The interest rate on the mortgage may be fixed or variable. The borrower is expected to pay the amount of the loan as well as the additional interests over a fixed term. The most common terms are usually 15 and 30 years. However, if the borrower falls short on payment, the lender can reclaim the property in a process known as a foreclosure. When this happen, the lender resells the property, usually at an auction in order to get back their money.
What happens in the event of a default?
In the event of a default, this mortgage is considered the foremost over subsequent loans made against the value of the home like the home-equity loans or home-equity lines of credit (HELOCs). The initial lender must be paid off completely before subsequent lenders get any payment from a foreclosure sale.
How a home-equity loan works
A home-equity loan is also a type of mortgage. But there’s a huge difference compared to the regular mortgage. The difference between a traditional mortgage and a home-equity loan is that a borrower gets a home-equity loan after they already owns the home, while he gets the mortgage to buy the property.
A home-equity loan is obtained by the equity in the home: this is the difference between the home’s value and the homeowner’s current home balance. For example, a homeowner who owes $200,000 on a property valued at $500,000 has $300,000 in equity. If such homeowner has a good credit and is eligible, he can obtain an additional loan using his home equity as a collateral.
Similar to a traditional mortgage, a home-equity loan is an installment loan repaid over an agreed period of time. However, various lenders have different standards regarding the percentage of a home’s equity they are ready to lend and they consider the borrowers credit before making that decision.
Home-Equity loan vs. Mortgage
Any homeowner who wants to use his home’s equity to pay off higher interest debt like a credit card debt or to make home improvements has a precise decision to make. He has the option to either refinance his mortgage balance and the additional cash out, with a regular mortgage, or he can do without his regular mortgage and obtain a home-equity loan on the top of it.
One of the key metrics to consider in this situation is the interest rate. A borrower who has a very low interest rate on his current mortgage should just let it be. So he should use a home-equity loan to borrow the additional funds he needs.
Nonetheless, if mortgage rates have dropped significantly since the homeowner got his current mortgage, a full refinance could be his best option. Looking at the latter case, the borrower gets the chance to save on the additional amount he borrows. This is because regular mortgages carry lower interest rates compared to home-equity loans. Even more, the borrower gets the opportunity to secure a lower rate on the balance he is owing.