A traditional mortgage is a loan taken out to buy a property. It typically requires a down payment and can offer different types of interest rates, such as fixed and adjustable. Home equity loans are used by borrowers to tap the equity that has accumulated in their existing homes for financial needs. Both use your home as collateral, or security, for the debt. This means that the lender can seize the home if you don’t keep up with your payments.
The interest on mortgages and home equity loans can be tax-deductible in some situations, up to certain limits.
Key Takeaways
- A mortgage is primarily used to purchase a home or property, while a home equity loan taps into a home’s existing equity.
- Mortgages can have fixed or adjustable interest rates and typical terms range from 15 to 30 years.
- Home equity loans usually carry higher interest rates but lower closing costs than first mortgages.
- Interest on both mortgage and home equity loans can be tax-deductible under specific conditions.
Investopedia / Sabrina Jiang
Understanding How Mortgages Operate
Mortgages are loans to buy a home or other piece of property. They come in two basic types: conventional mortgages and government-backed mortgages. In both cases, the lender is a financial institution, such as a bank or credit union. While the U.S. government backs some mortgages as a way of lessening lenders’ risks and making mortgages more widely available, it does not issue them.
Conventional mortgages require that you make a down payment, covering a portion of the home’s purchase price. The mortgage will cover the rest. For example, if you’re buying a $300,000 home and make a 20% down payment of $60,000, your mortgage will be for $240,000.
Although 20% down payments were once standard, many lenders will now accept considerably lower ones.
However, it’s worth noting that if you put less than 20% down on a conventional mortgage, you will typically have to pay for private mortgage insurance (PMI) until your equity in the home reaches that level.
Government-backed mortgage options include Federal Housing Administration (FHA) mortgages, which allow you to put as little as 3.5% down. U.S. Department of Veterans Affairs (VA) loans and U.S. Department of Agriculture (USDA) loans require down payments as low as 0%.
The interest rate on a mortgage can be fixed for the entire term of the loan or adjustable, in which case it will change periodically. The most common terms for mortgages are 15, 20, or 30 years, although there can be other terms available.
Before getting a mortgage, it’s important to shop the best mortgage lenders to determine which one will give you the best rate and loan terms. A mortgage calculator can also be useful in comparing how different interest rates and loan terms would affect your monthly payment.
Exploring the Functionality of Home Equity Loans
A home equity loan is also a type of mortgage. However, home equity loans are for situations when you already own a property and have accumulated a sufficient amount of equity in it. Lenders generally limit the amount of a home equity loan to no more than 80% of the total value of your equity.
Home equity loans are secured by your equity, which is the difference between the property’s value and any existing mortgage balance. For example, if you owe $150,000 on a home valued at $250,000, you have $100,000 in equity. Assuming that you have good credit and that you otherwise qualify, you should be able to get a home equity loan using a portion of that $100,000 as collateral.
Like a traditional mortgage, a home equity loan is an installment loan that has to be repaid over a fixed term, which can range from five to 30 years. Home equity loans typically have a fixed, rather than adjustable, interest rate.
In addition, home equity loans often have higher interest rates but lower closing costs than traditional mortgages.
Fast Fact
If you default on either a first mortgage or home equity loan, the lender can seize your home through foreclosure. The lender can then sell the home to recoup its money.
Tax Benefits Associated With Mortgages and Home Equity Loans
The interest on both mortgages and home equity loans can be tax-deductible in some instances.
In the case of mortgages, interest is deductible on up to $750,000 in debt for married couples filing jointly and $375,000 for singles. However, it is deductible only if you itemize your deductions on your tax return rather than taking the standard deduction. Since the standard deduction was substantially raised in 2017, many taxpayers find it more advantageous simply to take it instead of itemizing. But it’s worth doing the math to see. (Different maximums apply to mortgages issued before Oct. 13, 2017.)
Home equity loan interest is deductible up to those same amounts, but only if you use the money to “buy, build, or substantially improve your home,” as the Internal Revenue Service puts it. That restriction is scheduled to expire in 2025 unless Congress renews it; if it expires, home equity loan interest would be deductible regardless of what you use the money for. As with mortgage interest, you have to itemize deductions in order to claim home equity loan interest on your taxes.
Note also that these limits apply to all of your housing debt combined for your main home and any second home. So if you have both a regular mortgage and a home equity loan, you can only deduct the interest on up to $750,000 (or $375,000) of your total debts.
Is a Home Equity Loan a Second Mortgage?
A home equity loan can be considered a type of second mortgage. However, you can take one out whether or not you still have a first mortgage on the home, as long as you have sufficient equity in your home to borrow against.
What Is the Difference Between a Home Equity Loan and a Home Equity Line of Credit (HELOC)?
The principal difference is that a home equity loan is a fixed, one-time lump sum that you pay back over time. A home equity line of credit (HELOC) is a revolving line of credit that you can tap as needed, similar to a credit card. Home equity loans also tend to have fixed interest rates, while HELOCs generally have variable rates.
Does a Mortgage or a Home Equity Loan Have Lower Interest Rates?
Can You Use a Home Equity Loan to Buy a House?
The Bottom Line
A mortgage is generally the initial loan taken to purchase a home while a home equity loan allows homeowners to access the equity in their home for financial reasons. Both financial products use your home as collateral, which puts your home at risk of being seized if you fail to make payments on your loan. As with any kind of loan, it’s important not to become overextended, just in case you suffer some financial reversal and cannot keep up with your debt payments.