Our home equity loan vs second mortgage guide is here to help you compare two of the most common options when wanting to release equity.
We break down both so you have a full understanding of what they are and then draw comparisons and highlight differences. Before you shop around for one or the other, you need to read this!
Home equity loan vs second mortgage
Home equity loans and second charge mortgages are both used as a way to borrow a lump sum – sometimes substantial amounts – using the equity in your home. Common reasons for borrowing against the equity in your home is to complete home renovations or for debt consolidation.
But that leaves the question: should you use a home equity loan or should you use a second charge mortgage? Is there even a difference?
Let’s start with how home equity works…
To know how a home equity loan or second mortgage really works, you first need to know what home equity is. If you already know how to calculate home equity, you can skip this section. But if you’re unsure, keep reading.
Home equity is a term that refers to the value of your home you own outright without any lines of credit attached (debt!). For most of us, the debt is just the mortgage we used to buy the property. Home equity can be given as a financial value and it can be worked out as a percentage of the property.
We start by finding out the current market value of the property, which is not the same as how much you bought it for. The real estate market changes quickly and your home may have changed value. Once you know the home’s value, you need to subtract the original mortgage balance.
For example, if your home is worth £140,000 and you have a £70,000 existing mortgage, you have £70,000. And the amount of equity you would have as a percentage would be 50%.
What is a second charge mortgage?
Second charge mortgages are when the homeowner takes out a second mortgage on the same property by borrowing against the home equity they have built up through years of mortgage repayments. This gives them a loan amount that is repaid monthly, possibly with fixed interest which switches to a variable rate of interest – as many first mortgages do.
The first charge mortgage is the mortgage initially taken out when the property was bought, and it uses the home as collateral in the agreement. The second charge mortgage is a separate loan amount secured against the home equity the homeowner has built up.
A second charge mortgage is sometimes referred to as a second mortgage as well, but this can be confusing because someone could get a second mortgage to buy a second property. This is not the type of second mortgage we’re talking about in this guide.
What are the benefits of a second mortgage?
A second mortgage benefits a homeowner needing a loan in many ways:
- It allows them to borrow against their home’s equity
- The money is paid out as one lump sum
- Loan amounts from second mortgages can be used as the homeowner wishes without restrictions. As mentioned, most use the money for renovations and consolidating debts.
- Borrowing against equity can help them borrow larger amounts that other credit options (discussed later)
- Using equity as collateral could help the homeowner access competitive mortgage interest rates. However, second mortgages are typically more expensive than a first mortgage.
- First mortgage providers usually offer second mortgages as well, meaning there are many options.
What is the downside to a second mortgage?
As with all credit options, a second mortgage also has its disadvantages. When you take out a second mortgage, you risk being forced to sell the property if you do not pay it back as agreed with the lender.
It will also take you longer to pay off both mortgages, meaning it will probably take longer for you to own the property without any debt attached to it. Moreover, if house prices fall, you’re at risk of negative equity where you’re paying more to buy the property that it is currently worth.
Another drawback is the loan fees and closing costs you’ll have to pay by opening a second mortgage. Because this is a separate debt not tied in with your first mortgage, you may have additional fees and charges to pay.
What is a home equity loan?
A home equity loan is a type of personal loan secured against some of the home equity you have built up in your property. You receive a lump sum that has to be paid back over a fixed repayment period through monthly payments, just like a mortgage. Most of the time these loans have a fixed interest rate for their entirety, which can be anywhere from a couple for years to over a decade.
However, also like a second charge mortgage, if you do not repay the lender can initiate foreclosure and ask you to sell your home to pay it back.
What are the benefits of home equity loans?
For those needing credit with home equity available, there are many benefits of home equity loans, such as:
- These loans enable homeowners to borrow against their equity
- The money is paid to the homeowner in one large payment
- They potentially allow the homeowner to borrow large amounts that may not be available through another type of personal loan, especially unsecured options.
- You can use the money for any purpose you wish
- Because the loan is secured with home equity, you can find competitive interest rates compared to unsecured credit.
What is the downside of a home equity loan?
The major downside of a home equity loan, aside from putting you at risk of foreclosure, is that it comes with additional loan fees and charges, not least the closing costs. These costs can be hundreds or even thousands of pounds, depending on how much you borrow.
Similar to a second mortgage, it’s likely to take you longer to pay off the debts and own the home outright, and it does increase exposure to negative equity.
Can you get a home equity loan with a poor credit score?
Home equity loans must be applied for and the lender will assess your personal circumstances before approving the loan. Anyone with a poor credit score will find it more difficult to access a home equity loan. However, the same can be said about other credit options, including second charge mortgages.
If your credit rating is low, you may want to try and improve it before applying. One way of doing this is by looking for mistakes on your record that will be making your score lower than it should be. Use a credit reference agency to do this, some have free trials!
How much can you borrow on your second mortgage or home equity loan?
When you use a home equity loan or second mortgage, you borrow against home equity only. It is the equity that secures the credit agreement and therefore the equity is what determines how much you can borrow.
It is unlikely that the lender will allow the homeowner to borrow against all of their home equity as this is risky for everybody. If the property decreased in value then the homeowner could get themselves into negative equity due to borrowing against too much of their equity.
Most lenders will allow homeowners to borrow against a maximum of 85% home equity in either of these products. This percentage is known as a loan to value (LTV) ratio, i.e. the loan amount against the value of the security (home equity). Your loan to value ratio may be affected by income, existing debt and your credit score.
This means if you have £100,000 equity, the loan could be around £85,000 at most. Some lenders may also apply minimum loan amounts of around £10,000.
Is a home equity loan considered a second mortgage?
If you hadn’t noticed already, a home equity loan and a second charge mortgage work in identical ways. They both allow the homeowner to borrow against their home equity as a separate debt to their initial mortgage. And the homeowner can use the loan amount as they wish. Both options are frequently used to renovate homes, which can actually increase their value and increase home equity again.
Even the pros and cons of these products are similar, if not exactly the same!
It is for these reasons that many people consider a home equity loan as a type of second charge mortgage. You can find plenty of articles online where experts refer to second charge mortgages as a mortgage but also as an umbrella term for home equity loans and home equity line of credit (HELOC). We explain the latter towards the end of this guide.
What is the difference between a second mortgage and home equity loan?
So, if even experts consider them the same, are there any differences between second mortgages and home equity loans? Well, on the whole not really. You might have to go to different types of lenders to get them.
Second mortgages are exclusively available through lenders that are authorised to provide mortgages, which usually means speaking with a bank or building society. Home equity loans are also available through these lenders, but they may also be advertised through some online finance companies that provide other loan types.
There are bigger differences between a second mortgage and home equity line of credit, which are discussed soon.
Home equity loan vs second mortgage – which one to choose?
Because home equity loans and second mortgages are highly identical, there is no way to say which one is the best option for you. Instead, you should assess both options to look for the most advantageous repayment terms, considering the interest rate offered and any additional loan fees.
Even if they had significant differences, it would still be difficult to tell readers which one to choose. When you are considering taking out any type of loan, the best option will be determined by your personal circumstances, finances and preferences. Sometimes a poor credit score will stop you from accessing your preferred option.
You may also want to consider remortgaging and borrowing extra from your equity.
What is a home equity line of credit (HELOC)?
A couple of times during this guide we have references a home equity line of credit, simply known as a HELOC. This is a variation of a home equity loan. It also allows a homeowner to access credit using their home equity, but there are some major differences between the two.
How does a HELOC work?
Home equity lines of credit allow the homeowner to access funds secured against their home equity in instalments over a draw period. The homeowner can draw money from their loan as they need it for a set period.
During this time, they only pay interest on the amount they borrow, rather than repaying the capital and interest. If you’re struggling to imagine how it works, think of it like a credit card. Someone could draw money from an agreed amount on a credit card over time.
Once the draw period is over, the homeowner must then repay the loan amount over a fixed period of time with monthly payments. Unlike a home equity loan, a HELOC typically has a variable interest rate.
HELOCs Vs second mortgages
If a HELOC has some key differences to a home equity loan, that would make it different to a second charge mortgage too. So how do a HELOC and second mortgage compare?
Some of the big differences between HELOCs and second mortgages are how the money is accessed and how repayments are structured.
You may prefer to use a HELOC if you are renovating in stages and want to keep on top of a budget. The draw period allows you to structure loan payments in step with the project stages.
You should check interest rates and meticulously check the terms of any home equity loan, HELOC or second mortgage.
Other ways of accessing credit, either secured with home equity or not, include:
- Unsecured personal loans
- Secured personal loans
- Credit cards
- Home improvement loans
- Debt consolidation loans
- Equity release mortgages for seniors, e.g. lifetime mortgage
More FREE second mortgage information!
For more free information and clear answers to FAQs, stick with our guides and posts at MoneyNerd. We’re on a mission to keep readers informed about credit options, including home equity loans, HELOCs and second charge mortgages.
Come back to our site if you have another question about any of these financial products. It’s likely we’ve already published a new guide on it!