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This article first appeared on the Credible blog.
There’s some confusion surrounding the terms “second mortgage” and “home equity loan.” So, let’s be clear: A home equity loan is a type of second mortgage. But that’s not all you should know.
Here’s what else you need to know about second mortgages and home equity loans:
Credible doesn’t offer home equity loans or HELOCs, but if you’re interested in a cash-out refinance, Credible can help. You can compare mortgage refinance rates from various lenders, all in one place.
What is a second mortgage?
A second mortgage is another home loan taken out against an already-mortgaged property. They are usually smaller than a first mortgage.
The two most common types of second mortgages are home equity loans and home equity lines of credit (HELOCs).
Like a first mortgage, your home is used as collateral for a second mortgage. Should a foreclosure happen, the first mortgage lender is first in line to get repaid. The second mortgage lender is repaid next.
Good to know: Since second mortgages are riskier for the lender, their interest rates tend to be a bit higher than interest rates on first mortgages.
What is a home equity loan?
A home equity loan is a type of second mortgage that lets you borrow against your home’s value. You’ll get the funds from a home equity loan in a lump sum — similar to a personal loan — and the loan’s interest rate will be fixed.
By contrast, a HELOC allows you to borrow smaller sums as needed, and the interest rate is usually variable. Traditionally, you’ll need to retain 20% equity in your home to qualify for a home equity loan.
Here’s an example of how someone could access their equity through a home equity loan:
Home value: $250,000
Mortgage balance: $150,000 or 60% of the home’s value
Equity to retain: 20% or $50,000
Equity available to borrow: 20% or $50,000
Tip: Some lenders might allow you to retain as little as 10% equity when you take out a second mortgage, but they might also require you to pay for private mortgage insurance or charge you a higher interest rate.
While a home equity loan would give you $50,000 upfront in the above example, a HELOC would give you access to a $50,000 line of credit. You might never borrow the full $50,000, and you’ll only pay interest on the amounts you actually borrow.
Here are the most important differences between a home equity loan and HELOC:
An alternative to second mortgages
One alternative to a second mortgage is a cash-out refinance. With a cash-out refi, you pay off your existing mortgage with a new, larger mortgage and pocket the difference.
Tip: You can use the cash from a cash-out refinance however you want, just like you can with a home equity loan or line of credit. Like those options, you’ll need to have 20% equity left after the cash-out refinance unless you’re willing to pay private mortgage insurance.
The biggest benefit to choosing a cash-out refinance over a second mortgage is that cash-out refinance rates tend to be lower. This is because a cash-out refi is a first mortgage. The biggest drawback is that since you’ll be getting a larger loan, your closing costs, particularly the origination fee, may be higher.
Credible doesn’t offer home equity loans or HELOCs, but Credible can help you compare mortgage refinance rates, including those for a cash-out refinance.
About the author: Amy Fontinelle is a mortgage and credit card authority and a contributor to Credible. Her work has appeared in Forbes Advisor, The Motley Fool, Investopedia, International Business Times, MassMutual, and more.