Mortgage versus Home Equity Loan – Complete Analysis
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Home equity is the value of your home you own outright with no existing debt to be repaid. For most people, this is easily worked out by subtracting the existing mortgage away from the current market value of the property.
Most UK homeowners have tens of thousands of pounds of equity in their home, and they can access it to pay off other debts, complete home improvements, buy cars and so much more. A mortgage and a home equity loan are two methods of doing just that. In this guide, we look at the mortgage vs home equity loan argument for accessing home equity.
Is a second mortgage and a home equity loan the same thing?
A second mortgage and a home equity loan are not the same. They can be both used to access home equity, but a mortgage may not be exclusively used for this reason. Whereas home equity loans are always chosen to utilise equity, a second mortgage can be used to save money on mortgages without touching any equity at all. However, sometimes a new mortgage is used for equity release.
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Can I use a mortgage to release equity?
You can remortgage to release equity, also known as cash-out refinancing or overborrowing. This is when you swap your current mortgage for a bigger mortgage.
For example, your original mortgage balance might be £100,000 with £100,000 home equity (therefore your property is worth £200,000). You then remortgage by looking for second mortgages that will allow you to borrow the initial £100,000 to pay back the first mortgage and extra money that is borrowed against your home equity. If you had a home improvement project in mind that will cost £15,000, you may look for a second mortgage of £115,000 instead of just £100,000.
Keep in mind that this is a simplified example and other factors may need to be considered, such as early repayment fees.
Does my mortgage go up if I take out equity?
If you take some of your equity out of your home within the new mortgage then the loan amount you are asking for increases, and so may the repayment period. Therefore, it is likely that your monthly payment and/or interest rate will increase.
However, this will be determined by individual circumstances and your credit score. If you can get a significantly better mortgage deal today than when you took out your first mortgage, you may not be paying more in monthly payments.
The pros and cons of remortgaging for equity release
- Keeps all debt together, unlike using a home equity loan
- Access large amounts of money based on your equity
- Second mortgages may earn you a cheaper interest rate, depending on how you have handled your finances since taking out your previous mortgage.
- Closing fees, which are also in many equity loans
- Early repayment fees on the first mortgage
How much equity can I borrow from my home?
Lenders use a lot of data to determine how much they are willing to lend as part of a new mortgage. One of the most important statistics is the loan to value ratio, also expressed as LTV.
The LTV is a ratio between the maximum loan they will offer against the value of the asset. Generally, the most equity you can borrow against is between 80% and 85%. So, if your home equity is £50,000 you may be able to borrow an absolute maximum of around £42,500.
This also applies to using a home equity loan, which we will discuss further right now.
Using a home equity loan
What is a home equity loan?
A home equity loan is a special type of loan that allows you to borrow against your home equity based on LTV as explained above. It adds a new debt secured against your home, meaning if you do not repay you could lose it. However, whereas a mortgage lender can repossess the property for failure to repay (and then sell it), a home equity loan provider can force you to sell it to repay, known as foreclosure.
The loan is paid out to the homeowner(s) in one lump sum. Repayments begin straight away usually with a fixed monthly interest rate. You can use the money for any reason you wish. If you decide to complete home renovations you might increase the property value and your home equity in the process.
The difference between an equity loan and equity line of credit (HELOC)
Home equity loans are similar to a home equity line of credit (HELOC). They allow you to borrow against the equity in your home whilst using the home as collateral. But the biggest differences are in how the money is provided and how it is repaid.
With a home equity line of credit, the homeowner does not receive a lump sum. They can access the funds over a set timeframe called the draw period. This credit line is accessible when the homeowner needs it, somewhat the same as you can access money from a credit card. During the draw period, the homeowner only pays the interest rate on the amount drawn down from the line of credit. After the draw period, they must then pay back the loan and the interest.
Finally, the other difference is that a home equity loan uses a fixed rate of interest and a home equity line of credit uses a variable interest rate.
Is a home equity loan a separate payment from your mortgage?
Home equity loans and home equity lines of credit allow you to borrow money against the equity and are separate from any mortgage you may still have to repay. This means the debt attached to your property is not together. You may be able to get mortgages and home equity loans from the same lender, but this would still make them separate debts.
The benefits of home equity loans and HELOCs
The pros of choosing to use a home equity loan or HELOC are:
- You will still have your existing mortgage and can avoid early mortgage repayment fees
- These options offer low-interest rates comparable or even better than a first mortgage
- Potential to access a large amount of money in a lump sum or line of credit, as preferred
What are the downsides of a home equity loan?
The downsides of using a home equity loan are that your home is used as collateral and if something goes wrong you may be forced to sell it. This is also the case for remortgaging to release equity.
Two other downsides of equity loans and HELOCs are that it adds a second debt to the property, making it harder to budget for your mortgage and this debt at once. It’s not as streamlined or efficient, and you may require budgeting support. Consequently, you may have to pay fees for the property to be revalued as well.
The other downside is potential closing costs using these methods. Closing costs can be included within equity loans and HELOCs and are payable at the end of the repayment period. They are usually a couple of per cent of your total amount of borrowing, which can be thousands of pounds depending on how much equity you released. However, many mortgages also incur closing costs too.
Why is a home equity loan a bad idea?
A home equity loan is sometimes considered a bad idea because it puts your home on the line. However, with responsible lending, accurate budgeting and no unforeseen circumstances cropping up, it can be a smart way to access a lot of money at a lower rate of interest.
Mortgage Vs home equity loan – what’s better?
There are some subtle differences between home equity loans and mortgages. We have summarised them from our discussion above here:
- Mortgages keep debt together and are easier to budget for
- Home equity loans can avoid early repayment fees on replacing a mortgage
- Both options could get you a better interest rate
- Remortgaging may prevent you from having to pay for your property to be valued again
- Home equity loans and mortgages may be subject to closing costs (consider these fees!)
What’s better can only be determined by a professional personalised assessment and what is available to you.
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For more help understanding the difference between equity release products, or for more information on equity loans, don’t hesitate to come back to MoneyNerd.