Home Equity Loans versus Second Mortgages
(Updated November 2014)
A "second mortgage" is a broad term used to describe any other loan secured by the equity in your home in addition to the primary, main mortgage you're using to purchase it. The most common examples include a home equity loan, a home equity line of credit or a "piggyback" loan covering part of the purchase or refinance cost as a moneysaving tactic.
A second mortgage works much like the first (primary) mortgage you took out to buy your home, except that it's "second in line" if you default and the lender needs to be repaid. This represents a somewhat higher risk to a lender. As a result, you'll pay proportionately higher points and fees and have a higher interest rate than you would on a primary mortgage.
A second mortgage shouldn't be confused with refinancing, where one replaces their current mortgage with a new one that has different terms (possibly a lower rate or shorter payoff). While the new, refinanced mortgage may be the second one you've had since buying the home (or the third, fourth, etc.), that isn't what is meant in the lending industry by the term "second mortgage."
The term "second mortgage" is sometimes used specifically to refer to a smaller mortgage taken out at the time a home is purchased or refinanced, in addition to the primary mortgage. When used in that way, it generally refers to a piggyback loan used to cover part of the purchase or refinance cost.
One reason for doing this might be to cover part or all of a down payment in order to avoid paying for private mortgage insurance. Another reason for a piggyback loan would be to cover the part of a jumbo mortgage purchase that exceeds the loan limit for conforming loans, so that the rest can be covered by a conforming loan at a lower rate.
Home Equity Loans
Home equity loans come in two main types: a standard home equity loan and a home equity line of credit, or HELOC. We'll cover the standard one first.
A standard home equity loan works in much the same way as a regular mortgage, but you won't pay as much in origination fees and finance charges. That's because those fees and charges are based on the loan amount and you're borrowing only a fraction of your home's value. As noted above, you will pay a higher interest rate than you would on a primary mortgage.
You receive a single lump-sum of cash at closing on a home equity loan and begin repaying the loan almost immediately, with the next billing cycle. The equity in your home serves as the collateral on the loan, and payments are made over a period of time according to a fixed schedule. Standard home equity loans usually have fixed interest rates that are unchanged over the life of the loan, though some lenders may offer adjustable rates as well.
You don't need to tell your lender what you're borrowing the money for; you can do with it as you wish. Although in some cases, certain lenders will make a semantic difference between a second mortgage and home equity loan, with the distinction that the former is used for home improvements and the latter may be used for any other purpose, such as buying a car, medical expenses, tuition payments and the like.
A home equity line of credit (HELOC), on the other hand, is more or less a license to borrow money. You're allowed to borrow up to a certain limit, secured by the equity in your home, on the schedule and in the amounts you wish. You don't have to borrow anything initially if you don't choose to; you can borrow the entire amount at once or you can borrow multiple smaller amounts as needed (this makes this type of loan popular for home improvement projects).
A HELOC has a certain period, called the draw, during which you can borrow against your line of credit. This is generally 10 years and during that time you're usually required to make interest payments only - you don't have to repay principal. The interest rate will usually be adjustable during this time.
Once the draw period is over, you begin to repay the full loan on a predetermined schedule, just as with a regular mortgage. The loan often switches to a fixed rate at this time.
Because their rates are adjustable, HELOCs tend to have lower interest rates than do standard home equity loans, at least during the draw period. Most do not charge origination fees, either, though there generally will be an annual fee charged during the draw period of the loan.
Security and Tax Advantages
Home equity loans and second mortgages of all types use your home as the underlying security, so you should only assume the responsibility for these kinds of loans if you are sure you can pay them back. Regardless of which loan you choose, you'll probably be able to deduct some of the costs of repaying your loan at tax time.
Because you'll pay more closing costs with a second mortgage, you'll have more opportunity for itemized deductions, which is something to consider before choosing which loan is best for you. Consult your tax planner to find out which type of loan provides the best advantages based on the methods used to calculate your year-end taxes.
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