Home Equity Loan vs. Mortgage: What's a Better Option

Should you apply for a home equity loan or a mortgage loan? The answer depends a lot on your goal:

• When buying your first home: You will need a mortgage loan to finance the purchase.
• When you already own a home: A home equity loan (or HELOC) can provide the money for home improvements or other needs, including the down payment on a second home.

To put it another way, a mortgage is key to becoming a homeowner. A home equity loan can get more out of your existing property.

How does a mortgage work?

A typical mortgage loan covers most of a home’s purchase price. For example, let’s say you’re buying a home that costs $400,000, which is slightly below the current median home price in the U.S. After paying 10 percent, or $40,000, down you’d still need another $360,000.

A mortgage loan fills this huge gap, eliminating the need to save another $360,000 before buying the home. After closing the loan and moving into the home, you’d start repaying the loan by making monthly payments with interest. 

How can a lender afford to risk so much money on the borrower’s behalf? Until the mortgage balance reaches $0, the lender keeps a lien on the home. The lien gives the lender the right to claim ownership of the home if you stopped making payments. 

Better can finance a variety of residences, including townhouses, condos, and even complexes with up to four units.

The amount of a loan’s monthly payments depends on the amount borrowed, plus:

The loan’s interest rate

Lower fixed interest rates create lower fixed monthly payments. For example, the payment amounts (before taxes and fees) on a $360,000 mortgage would be:

• $2,395 a month at 7 percent

• $1,933 a month at 5 percent

That’s a monthly savings of $462 for the same home financed over the same 30 years, all because of the loan’s fixed interest rate. At the end of those 30 years, the 5 percent borrower would have saved $166,320 in interest. It’s easy to see why people care so much about interest rates.

The broader financial markets help set a new loan’s fixed interest rate, but within that context, the individual borrower’s credit score and debt-to-income ratio also influence interest rates.

The loan’s term

Terms measure the loan’s repayment schedule. Most buyers get 30-year mortgages — since longer terms allow lower monthly payment amounts — but shorter terms are available, and they also have benefits.

On a $360,000 loan at 7 percent interest, a borrower would pay:

• $2,395 a month: on a 30-year loan

• $3,236 a month: on a 15-year loan

Why would someone choose to pay more each month? Because they’d own the home sooner and owe less in interest. Some homeowners like to refinance into loans with shorter loan terms later, when they earn more income and can afford a bigger monthly payment.

Additional taxes and fees

Along with paying down the loan’s balance, each month’s mortgage payment adds in smaller payments for property taxes, homeowners insurance premiums, and mortgage insurance premiums. 

The amount of these extra charges vary by borrower, lender, address, insurance company, type of mortgage, and so on. It’s common for a mortgage payment to include several hundred dollars to cover these charges.

How does a home equity loan work?

With a home equity loan or a home equity line of credit (HELOC), a homeowner can use their existing home as leverage to borrow more money. This borrowed money could be used to renovate the home, to buy more real estate, or to pay off other kinds of debt that charge higher interest rates. 

To get a home equity loan or a HELOC, a homeowner first needs to buy a home and build home equity, which is the portion of the home’s value that’s already been paid off. For example, if your home is worth $400,000 and you owed $200,000 on the mortgage, you’d have $200,000 in home equity. 

Typical lenders won’t allow homeowners to use all of this equity. Most require leaving 15 to 20 percent of the equity in the home. Better allows larger-than-average home equity loan sizes: Up to 90 percent of a home’s value. The borrower above, with $200,000 in equity, could get a home equity loan up to $160,000. 

 Home equity loans work a lot like personal loans. But with home equity serving as collateral, or security, on these loans, home equity borrowers can get lower interest rates and higher credit limits compared to using an unsecured personal loan or credit card. 

Opening a new home equity loan or line of credit (HELOC) will require a second mortgage payment each month. The homeowner also continues paying the first mortgage payment. 

Is a home equity loan the same as a HELOC?

Since they can exist alongside a first mortgage, HELOCs and home equity loans are both known as second mortgages. They both help existing homeowners borrow money from their home equity. 

But HELOCs and home equity loans work differently. Unlike a home equity loan, a HELOC doesn’t generate a large sum of money up front. 

Instead, a HELOC opens an equity-backed line of credit which the borrower can draw from as needed. Money can be drawn from the line of credit, repaid, and then drawn again. In this sense, a HELOC resembles a credit card with a much-lower interest rate.

Like a credit card, a HELOC has a revolving balance. That means the payment amount changes from month to month as the homeowner draws and repays funds. Later, often after the first 10 years, the lender closes the HELOC. At that point it can no longer be used to withdraw money, and the remaining balance must be repaid over the following 10 years.   

One more key difference: A HELOC’s variable interest rates change with the market while home equity loans normally lock in fixed interest rates.  

Home equity loan vs mortgage

Primary, or first mortgage loans can provide most of the cash needed to buy a home. 

Second mortgages such as a home equity loan or line of credit help people who already own a home borrow more cash for renovations, debt consolidation, college tuition, or any other future-focused need.

Here are some other key differences between these loan types:

Feature	Primary mortgage loan	Second mortgage (Home equity loan or HELOC)
Main purpose	Buying a new home	Converting home equity into cash through a loan against the equity
Interest rate type	Usually fixed, but adjustable rate mortgages (ARMs) are available	Home equity loans have a fixed interest rate; home equity lines of credit (HELOC) usually charge a variable interest rate
Loan repayment terms	Up to 30 years (occasionally higher)	Typically don’t exceed 10 years (HELOCs have revolving balances during their draw periods)
Borrowing limits	Based on home value, borrower’s credit profile, and loan type’s rules	Based on amount of home equity and borrower’s credit profile, including credit score and debt-to-income ratio
Time to close	Longer than home equity loan; often four to six weeks	Could close within two weeks; possibly shorter
Risks	The lender uses the home as collateral; borrowers who default on repayment could lose home	The lender uses the home as collateral; borrowers who default on repayment could lose home
Benefits	Ability to buy home with only a fraction of purchase price saved	Saving on borrowing rates compared to unsecured loans

Both loan options have a primary purpose, but some borrowers still find ways to use these types of mortgage loans interchangeably. 

For example, a homeowner could use funds from a second mortgage to buy a separate rental property or a vacation home. Or a homeowner could use a new primary mortgage, like a cash-out refinance, to access home equity. This strategy replaces an existing primary mortgage with a new primary mortgage. 

Mortgages and home equity loans tax deduction

A first mortgage loan charges thousands of dollars a year in interest, especially in the earliest years of the loan’s repayment term. Taxpayers can deduct this interest from their taxable income, lowering what they owe in taxes. 

To claim this benefit, a homeowner would have to itemize tax deductions rather than claiming that year’s standard deduction.

What about interest paid on a second mortgage? Before 2018, second mortgage interest could also be written off of taxes. Now the IRS allows this deduction only if the money from the second mortgage was reinvested into the home.

So, using the home equity loan or HELOC to add a bathroom, redo the HVAC system, or complete other home improvements? That’s tax-deductible interest. Using the loan to consolidate credit card debt or buy a new car? Not tax-deductible interest. 

Which option to choose

If you’re shopping for your first home, the answer should be simple: Only a mortgage can provide enough cash to get you through the door of homeownership where you can stop paying rent and start building equity to use in the future.

But if you already own a home and have built some home equity, a second mortgage could open up more options: 

• To buy a new home: You could use cash from a HELOC or home equity loan on your current home OR you could get a new mortgage and leave your current home equity untouched.
• To borrow cash from equity: You could use a home equity loan/HELOC OR a new mortgage that generates cash while also refinancing the existing mortgage.

How to decide? By comparing how much these loans would cost you. This isn’t always easy to do since a loan’s costs play out over time. 

Variables to consider include your existing loan’s interest rate, the rates you could qualify for today, how much equity you already have, your credit score and level of debt, the type of loan you have now, how much you need to borrow, the type of loan you’d be getting, the amount of interest you’ve already paid on your current loan. 

It’s a lot to balance.

Comparing loan costs side by side can show the better option

Mortgages, cash-out refinances, home equity loans, and HELOCs are financial tools. Like any tool, these loans work best when used at the right time and in the right way.

If you’re still not sure how to answer your home equity loan vs mortgage question, it’s time to get a loan estimate from a lender. Loan estimates from a lender show what you’d pay each month and over the entire loan term. 

That way you can compare loan costs side by side and see whether a home equity loan or a mortgage best meets your needs.