Second Mortgage vs. Home Equity Loan [Explained]

Have you built equity in your home? If so, it’s time to put it to work.

Whether you’re ready to pay off your medical school student loans, consolidate your debt, or finally upgrade to that new kitchen you’ve been dreaming of, you can use a home equity loan or second mortgage to achieve it.

However, these two options are different enough that they’re worth considering carefully so you can select the right option.

In this guide, we’ll explain the disparities and which loan is best for your financial needs.

How Home Equity Loans Work

First, let’s look at home equity loans, as this might ultimately be the direction you decide to take your financial future in.

This loan type is considered the simpler of the two, in part because of the predictable schedule.

Essentially, if you take out a home equity loan, you’ll receive the required cash as a lump sum.

However, you’re then on the hook to pay the money back, including closing costs.

You’ll begin repaying the home equity loan every month.

What happens if you fall a bit short or can’t afford to pay for the month?

You’re tying the loan to your home, hence why it’s called a home equity loan.

In other words, if you can’t pay or fall severely behind, you could lose your home.

An equity loan doesn’t replace your mortgage. Rather, it’s a separate payment.

So, you’d need to set aside the money for both every month if you want to keep enjoying life in your home.

Most homeowners who look into home equity loans do so for larger, one-and-done home improvement projects such as room renovations.

If you have a lot of credit debt you’re trying to put under control or student loan debt that’s nagging at you (or hurting your credit score), you can also explore home equity loans.

One of their biggest benefits besides their monthly predictability is that this loan has fixed interest.

That means that your interest won’t go up over the life of the loan.

In the case of some loans, you might find yourself exclusively paying off interest each month, never touching the actual loan amount.

That won’t be the case with home equity loans.

What Is a Second Mortgage?

A second mortgage is a little more straightforward.

As a homeowner, you’re aware that you pay a monthly mortgage to continue living in the home.

The mortgage doesn’t include utilities, groceries, or anything of that order, just payments on the property itself.

A second mortgage is an additional loan taken out against your property.

You can have the two mortgages concurrent with one another, so even if you haven’t paid off your first mortgage, you can request a second one.

You will receive a specific amount to borrow based on your home equity, which refers to your home value when you subtract the amount due on the first mortgage.

Under the second mortgage umbrella is a home equity line of credit or HELOC.

You have a selected draw period of 5 to 10 years (sometimes more and sometimes less).

During that period, you can take money periodically as needed, rather than as a single lump sum like with a home equity loan.

A home equity line or HELOC doesn’t require you to pay back the loan amount until the draw period ends, so you can go a lot longer before you’re expected to repay it.

These second mortgages have variable interest rates.

This usually means that the interest rates will start lower at the beginning of the loan’s life, and then increase with time.

However, if you aren’t ready for a sudden spike in the variable interest rate, you could find yourself unpleasantly surprised.

Just as a home equity loan requires you to pay your mortgage plus the additional loan, second mortgages demand the same of you.

That said, some homeowners explore a cash-out refinance, which upgrades your mortgage to a bigger one, giving you back the difference in cash.

If you don’t mind extending your mortgage repayment timeline, and if interest rates have dropped compared to when you obtained your mortgage originally, you could look into a cash-out refinance.

Be advised that second mortgages use your home as collateral as well, which means failing to pay interest or make regular payments on the loan could again result in the loss of your home.

Second Mortgage vs. Home Equity Loan: How They Compare

Selecting the ideal loan for you, from a second mortgage to a home equity loan, requires you to evaluate important factors like interest rates, the repayment period, and more.

Here’s a comparison of the two types of mortgages to help you make your decision.

Payment Type

HELOCs or second mortgages provide flexible payments.

If you wanted to gradually work on your kitchen, upgrading the dishwasher first and the microwave later, you’d have 5 to 10 years to make these home improvements under a second mortgage.

That gives you enough time to control your spending while still making the required changes.

Home equity loans provide a lump sum payment all at once.

You could upgrade your entire kitchen in one fell swoop rather than waiting to make improvements to the space little by little as you would with second mortgages.

Repayment Schedule

Both types of loans require you to continue paying your first mortgage, which is worth reiterating.

We also want to mention again that you will put your home as collateral with second mortgages and home equity loans, so neither of these loans is to be taken lightly.

You must begin paying back a home equity loan sooner, as HELOCs or second mortgages require you to wait for the draw period to end first.

The monthly payments are consistent under home equity loans, while with second mortgages, there are sometimes fluctuations in what you pay (due to changing interest rates).

Considering that you still have to pay your first mortgage while juggling a second mortgage, the unpredictability of payment can lead to financial strife if you aren’t ready for it.

Interest Rates

One of the biggest differences between these types of loans is the interest rates.

You’ll recall that home equity loans have fixed interest. In other words, the rates will not change over the life of the loan.

This allows you to financially prepare for that payment in addition to your first mortgage every month.

HELOC or second mortgage interest rates are variable, meaning they can change from month to month.

This can make paying off a second mortgage loan more difficult, as some months might be more expensive than others.  

Can You Take Out a Home Equity Loan or Second Mortgage?

Now that you’ve considered which type of loan is most suitable for you, let’s go over the criteria lenders look for when determining who’s eligible for these loans.

• Credit score: The better your credit, the more ideal the loan terms, which usually translates into lower interest. Your score should be at least 620, but a higher score is more advantageous.
• Debt-to-income ratio: The debt-to-income ratio determines how much of your monthly income is used for debt and dictates how well you can financially handle emergencies. A higher ratio is poor, so aim for around 43 percent.
• Equity: You must have invested in your home before you can explore taking out a loan on it. Your equity should be 15 to 20 percent.

Wrapping Up

The question of whether a home equity loan or second mortgage is more appropriate for you requires you to think carefully about your financial situation.

A second mortgage allows you to draw money for an extended period, but the variable interest rates can be tricky for some.

On the other hand, the consistent interest rate of a home equity loan is offset by the larger loan amount and the need to pay it back faster, as these loans have no draw period.

Ultimately, it’s your comfort with paying off loans and in what quantity that will dictate which is the best option for you.

Still not sure about the best option for you and your needs? Contact us at Physicians Thrive, and we’ll help you out!