Is a HELOC a Second Mortgage?
A home equity line of credit (HELOC) is not a traditional “second mortgage,” but it is essentially a loan that is secured by your home equity. Getting a second mortgage essentially means taking a lien against a property for which you already have a loan – hence the “second” mortgage.
How can you borrow money against property you don’t technically own outright? Although you might still owe the bank money for your home, you likely already own a significant portion of it. The percentage of your home that that truly own – in other words you’ve already paid it off – can be quantified.
For example, if your home is worth $500,000 and you owe your lender $200,000 on your existing mortgage, you have $300,000 of equity. All types of second mortgages and HELOCs allow you to borrow money against that $300,000.
The ability to open a home equity line of credit or take out a secured loan against your equity can be an incredibly powerful tool for families. Equity is where the majority of the average household’s capital rests. Unfortunately, that equity is extremely illiquid, meaning without some time of home equity loan you would only be able to access that money by selling your home and turning it into cash.
Many people find themselves in situations where they could really use that money, but they have no desire to sell their home, downgrade to a smaller or lower quality home and uproot and move their family. HELOCs are an easy way for you to access those illiquid dollars without having to go through the unpleasant and complicated process of selling your home and finding somewhere new to live.
What Is a HELOC?
Instead of a traditional lump sum loan where the bank writes you a check for the loan amount, HELOCs provide a revolving line of credit. This means that during the draw period borrowers can draw funds up to a predetermined credit limit as needed, repay the borrowed amount if necessary or convenient and then borrow again. You only pay interest on the amount you’ve drawn – not the entire credit limit value.
The draw period on most HELOCs is usually five to ten years, after which the borrower enters the repayment period, where they can no longer draw funds and must repay the outstanding balance and interest on that balance.
This line-of-credit structure instead of the lump sum structure is what separates HELOCs from a traditional second mortgage. If you take out a normal second mortgage, the bank will write you a check for the loan amount and you will be expected to make monthly principal and interest payments for a predetermined term – the same as a normal mortgage.
While second mortgages can have variable interest rates, they’re most often fixed-rate loans. HELOCs are typically variable-rate loans (although some borrowers may qualify for fixed-rate options as well). When a home loan has a variable rate (sometimes referred to as an adjustable-rate mortgage), the interest rate you’re charged over the life of the loan will fluctuate based on market conditions and the index rate (the prime rate). Your monthly payment and the interest you owe over the term of the loan will change as the rate changes.
With a fixed-rate second mortgage you know exactly what you’ll owe and what your monthly payments will be for the entire term of the loan as soon as you sign on the dotted line. Why would anyone choose the uncertainty of a HELOC over an adjustable rate second mortgage?
- Starting rates are often lower than fixed-rate alternatives
- Although it’s not the norm, rates can theoretically go down
- Variable-rate loans can be refinanced in the future to get a lower rate or a shorter term
The Flexibility of a HELOC Is Often the Key Selling Point for Borrowers
Loans are fundamentally situational. People often get them for a specific purpose, like paying for college, home renovations, starting a small business or consolidating debt. Second mortgages provide a one-time lump-sum payment, which might be suitable for homeowners who require a large amount of money for a specific purpose, especially if they require a definable, certain amount.
However, the expenses associated with those types of things aren’t necessarily completely predictable. You might change your mind, or your needs and expenses change as time goes on.
HELOCs allow borrowers to use the funds as needed, up to the credit limit, and only pay interest on the amount borrowed. This is starkly different from a traditional lump-sum second mortgage where you pay interest on the whole amount. This can be particularly beneficial for homeowners who have ongoing expenses or need funds over an extended period.
Is a HELOC Right for You?
Both HELOCs and traditional second mortgages allow homeowners to borrow against the equity in their homes. The loans differ in terms of loan structure, interest rates and flexibility.
In most cases, a HELOC will be a revolving variable-rate line of credit, while a second mortgage is typically a more traditional installment loan with a fixed interest rate.
It’s important to understand that neither option is inherently better than the other. Rather, there are specific scenarios in which one might be preferable to the other for a certain type of borrower.
This is why it’s so important to work with a lender who you can rely on for honest guidance and helpful advice. At OnPath Federal Credit Union, we have a vested interest in the financial health and success of our member owners, which is why our lending professionals can be relied upon to provide straightforward and easy to understand answers. We’ll help you weigh your options so you can make an informed choice.
Call our mortgage team today at 504.648.2064.