What's the difference between a second mortgage and a home equity line of credit (HELOC)? Both offer ways to tap into, or borrow against, the equity in your home. But there are some significant differences.

Many people might assume that the market for home equity loans of all types is effectively dead. After all, many lenders took major losses on home equity loans in the recent downturn and are wary of getting burned again. Falling property values have also wiped out much of the equity that home owners would need to secure such loans and credit is just much harder to come by these days.

But home equity loans are still being made, although at a much lower volume than in recent years. It's true that in highly volatile real estate markets that have seen major price declines, such as California, Florida, Nevada and Arizona, it may be extremely difficult or nearly impossible to get a home equity loan until home values stabilize.

But most parts of the country saw far more modest declines in property values than those hard-hit states, and many homeowners there still retain considerable equity in their homes. Lenders are more likely to view prices in those areas as less susceptible to further significant declines, particularly now that home prices are rising again, and may be more willing to consider home equity loans there.

Lump sum in a secondary mortgage

Generally, a second mortgage refers to single loan taken out and secured by the equity you have in your home. You get all the money in one chunk and pay it off over a number of years. The interest rate is typically higher than that on the primary mortgage, because the primary mortgage gets paid off first in the event of a foreclosure - so the risk is higher for the second mortgage lender if the property declines in value. But closing costs are less than on a primary mortgage, primary because the amount borrowed is much less.

A home equity line of credit (HELOC) is somewhat similar, but with a key difference. When you set up a HELOC, the bank agrees to lend you a certain amount, but you don't necessarily take out any money at that time. Instead, you have the ability to borrow any amount up to your credit limit as you need it, and pay it back over time. You pay certain fees to set up the HELOC, but these tend to be less than for a second mortgage.

HELOC provides flexibility

The nice thing about a HELOC is that it provides flexibility. Say, for example, that you want to borrow against your home equity for a number of home fix-up projects you plan to take on. Instead of borrowing one big lump sum all at once, the HELOC allows you to borrow smaller sums as you need them over time and pay them back - so you're only paying interest on whatever you've borrowed, not the maximum you can take out.

A second mortgage, on the other hand, is nice for when you need just one lump of cash for a single purpose. For example, instead of a number of do-it-yourself projects, suppose you're hiring a contractor for one large project, such as adding an extra room. You take out a single loan to pay the entire cost. The interest rate is typically lower than on a HELOC, and you can get a fixed rate as well, while the rate on a HELOC tends to fluctuate over time. However, you have to make sure you borrow enough up front to cover the cost of whatever you're planning to finance - unlike a HELOC, you can't dip back in for more cash if you run out of money.

Lenders have tightened up their lending standards over the past year, particularly for second mortgages and HELOCs. In many cases, you're likely to find lenders won't authorize any loans that, when combined with the balance on your primary mortgage, go beyond 70 percent of your home equity. So to qualify, you're going to need significant equity in your home to begin with. But if you can meet that standard, it's still possible to get a home equity loan to finance a home improvement, education costs, investments or other major expenditures you wish to pursue.

Published on September 19, 2009