Second Mortgage vs. Home Equity Loan: Which Is Better?

Owning a home can yield valuable benefits, including the opportunity to grow home equity. Equity is the difference between what you owe on the home and its fair market value. There are several ways to tap into this equity, including a second mortgage. But what is the difference between a second mortgage vs. a home equity loan? This is what to consider to grow your own home equity.

If you’re considering making use of the equity you’ve built up in your home, consider meeting with a financial advisor about whether it’s the right move for you.

What Is a Second Mortgage?

A second mortgage is any mortgage loan that’s subordinate to a first mortgage.

Typically, a first mortgage is a loan you use to buy a home, so it is usually larger than a second mortgage. The home serves as collateral for a second mortgage.

Like a first mortgage, you must repay the loan over time with interest. This means if you have both a first and second mortgage, you’ll have two monthly mortgage payments.

If you default on either mortgage loan, the first mortgage lender takes priority over the second mortgage lender for repayment. This means that if the home goes into foreclosure, you will pay the first lender before the second. Therefore, it’s possible the second might receive little, or even nothing at all.

Second mortgages tend to have higher interest rates than first mortgages for that reason. A borrower who now has to make two mortgage payments instead of one presents a greater risk for the lender. This is why they compensate with higher interest rates to offset the possibility of borrower default.

What Is a Home Equity Loan?

A home equity loan allows you to borrow against your home’s value. In simpler terms, it’s a second mortgage.

When you take out a home equity loan, you withdraw equity value from the home. Typically, lenders allow you to borrow 80% of the home’s value, less what you owe on the mortgage. Some of the best lenders may even increase this to 85%.

For example, say your home is worth $575,000, and you owe $350,000. Using the 80% rule, the most you can borrow against your equity is $110,000.

$575,000 x .80 = $460,000

$460,000 – $350,000 = $110,000

You receive the proceeds from a home equity loan as a lump sum, which you can use however you like.

There are several common uses for home equity loans.

Home improvements or repairs
Debt consolidation
Large purchases
Wedding expenses
Vacation expenses
Medical expenses
Education expenses
Business expenses

You must pay the loan back with interest. Depending on the loan terms, repayment may last anywhere from five to 30 years.

Second Mortgage vs. Home Equity Loan

When comparing second mortgages vs. home equity loans, you’re really talking about the same thing.

A home equity loan is a second mortgage on a home that you secure using an underlying property. Therefore, neither is better, since they refer to the same thing.

There are some pros and cons associated with having a second mortgage on your home.

Pros of a Second Mortgage

The main benefit of a second mortgage is accessing your home’s equity.

A home equity loan offers flexibility, in that you can use the money for just about anything. This means you can invest in your home by overhauling your kitchen, for example, to improve your home’s value. You can also use the money to consolidate and pay off high-interest debt.

Home equity loan interest rates are often much lower than credit card or even personal loan rates for borrowers with good credit scores. Opting for the shortest loan term possible can help you pay off a home equity loan faster, though this will mean a larger monthly payment.

The interest on a home equity loan may be tax-deductible if you’re using the proceeds to buy, build or substantially improve the property securing it. This means if you renovate your kitchen to increase the home’s value or replace your HVAC system, you can write off the interest.

However, the IRS has strict rules, so it is wise to talk to your financial advisor about what is and isn’t allowed.

Cons of a Second Mortgage

The biggest drawback of using a home equity loan as a second mortgage is that it’s secured by the home.

This means that if you run into trouble making payments on the loan, you could be at greater risk of default and, eventually, foreclosure. Not only will you lose the home, but you will also lose the entire investment you’ve made over the years.

How to Decide Whether to Borrow Against Your Home

A home equity loan can provide access to a substantial amount of money, but the decision should involve more than comparing interest rates. Because your home secures the loan, it helps to consider whether the purpose of the borrowing justifies taking on additional debt.

Many homeowners use home equity for projects that may provide a long-term financial benefit. Major renovations, replacing an aging roof and consolidating higher-interest debt are all common examples because those funds improve an asset or reduce borrowing costs. In these situations, the loan may strengthen your overall financial position if the payments fit comfortably within your budget.

Using home equity for discretionary spending presents a different calculation. Financing vacations, luxury purchases and everyday expenses can leave you with loan payments long after those purchases have lost their value. While the monthly payment may appear manageable, the total borrowing cost can increase significantly over a repayment period that lasts 10, 15 or even 30 years.

It is also worth considering how long you expect to own the home. If you anticipate selling in the near future, closing costs and financing charges may outweigh the benefits of borrowing against your equity.

Calculating the total cost of the loan, rather than focusing only on the monthly payment, can provide a better basis when deciding whether using home equity is the right financial move.

Home Equity Loan vs. HELOC

A home equity line of credit (HELOC) is another type of second mortgage loan. Like a home equity loan, it’s secured by the property, but there are some differences in how the two work.

A HELOC is a line of credit that you can draw against as needed for a set period, typically up to 10 years. After the draw period ends, you enter the repayment period, which may last up to 20 years. During this stage, you repay the amount you drew from the line of credit, plus interest.

HELOCs can have variable interest rates, while home equity loans more often have fixed interest rates. The amount you can borrow may be higher compared to a home equity loan. For example, lenders may use a 90% equity limit in determining HELOC amounts.

Both home equity loans and HELOCs can have upfront fees.

Which Is Better? Home Equity Loan vs. HELOC

The answer depends on the reason for tapping into your equity.

For example, say you want to make some major home improvements, but you aren’t exactly sure how much money you’ll need. You may choose a HELOC since you’ll have a flexible line of credit available as needed. The HELOC has a variable rate, but you hope rates will stay low over time.

On the other hand, say you know you need exactly $50,000 to fund home updates. You may prefer a home equity loan with a fixed interest rate, as it can offer greater predictability in payments and overall cost. The downside here is that if you go over $50,000 for your project, you may need to take out another loan or use a credit card to finish it.

Using a home equity calculator can help you estimate how much you may be able to borrow and the kind of rates you’ll likely qualify for. Keep in mind that as with first mortgages, qualifying for a second mortgage can depend on factors like your credit score, income and debt-to-income (DTI) ratio.

Bottom Line

Whether a second mortgage vs home equity loan is a good idea for you depends on what you need to tap into your equity for.

Whether you call it a second mortgage or a home equity loan, it means the same thing. Withdrawing from your equity can put cash in your hand when you need it. But consider the cost, being mindful of both interest rates and repayment terms, and how having two mortgages can affect your monthly budget.

Mortgage Planning Tips

Consider talking to a financial advisor about the pros and cons of taking out a second mortgage and whether it might be right for you. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have free introductory calls with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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