The Differences Between HELOCs and Mortgages

After you have equity in the property, you can borrow against it in a couple of ways

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HELOCs, Mortgages, Homeowners
When you purchase your home, the original loan agreement is called a mortgage. Pixabay

Homeowners often wonder about the different ways they can borrow against the built-up equity in their homes. For the average consumer a house is the largest investment they’ll ever make and is usually the best source of additional funds when an emergency arises or a special project is in the works. When you purchase your home, the original loan agreement is called a mortgage, or the first mortgage. Later, after you have equity in the property, you can borrow against it in a couple of ways: one is by taking a second mortgage and the other is with a home equity line of credit, or HELOC.

There are many differences between a HELOC and a second mortgage and each financing method has its own set of pros and cons. The main thing to keep in mind is that you should choose the loan arrangement that works best for your particular needs. In general, the HELOC offers a variable rate and works much like a standard credit card. A second mortgage is more akin to a traditional loan, with a fixed interest rate and a set payback period. Here’s a quick summary of the key points about HELOCs, second mortgages and when you might want to use them:

Funding Methods

With a HELOC, you’re really getting a line of credit rather than a fixed amount of funds at a specific time. A second mortgage is almost identical to a first mortgage in most ways. The second mortgage, once the contract is finalized, delivers a check to the borrower for whatever amount of funds was agreed upon, at a fixed interest rate for a specified term.

HELOCs, Mortgages, Homeowners
For the average consumer a house is the largest investment they’ll ever make. Pixabay

Reason for Needing Funds

Homeowners who want a lump sum of cash for a specific reason like taking a big vacation or making a major purchase usually prefer a home equity loan. Those who just want to have a line of credit for a long-term project that might have changing financial demands along the way will often opt for a HELOC.

Tax Treatment

Under the most recent tax legislation (TCJA: Tax Cuts & Jobs Act), you can deduct the interest you pay on a second mortgage, but on HELOCs, you can only deduct the interest is you use the money to improve, build or purchase the property you’re borrowing against.

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Interest Rates

Most second mortgages offer fixed rates of interest while HELOCs carry variable rates. Note that some HELOCs can be converted to fixed-rate loans after a certain amount of time. Also, borrowers who take out second mortgages will see their interest rates determined by a combination of the amount of equity they have and their credit scores. In most cases, HELOCs have lower interest rates, even though those rates are variable.

Payback

A second mortgage is a straightforward instrument. You borrow X amount of money, using your home as collateral, and pay it back over a specified number of months at fixed monthly payment amounts. With a HELOC, there’s a “draw period,” during which you make payments of principal and interest. After that, you enter the repayment period, with no more cash withdrawals allowed. And because HELOCs feature variable interest rates, your monthly payments fluctuate.