There are many situations in life where we may not be able to afford expenses upfront, and that is why loans can be a valuable tool.
If you are purchasing a home, doing renovations, or require emergency funds, there is a good chance that you will need a loan. There are many different types of loans relating to homes and properties, so how do you know which is right for you?
While it is always best to talk to a mortgage broker or financial professional about your specific situation, it is helpful to do your research in advance to have an idea of what might be best for you. That way, you will be up to date on all of the information needed to make an informed decision.
Two of the most common types of loans are traditional mortgages and home equity loans. While both types of loans share some similarities, there are also a few key differences between the two. Let’s explore both options below.
What is a Traditional Mortgage?
A traditional mortgage is one of the most common types of loans that a homeowner takes out. Many homebuyers require a mortgage in order to borrow an amount of money to pay for a property they are purchasing.
Often, the homebuyer pays 5-20% of the purchase price as a down payment, and the mortgage loan will cover the rest of the cost. Then, the borrower will pay off a set amount of the loan each month plus interest for a period of time, often 20-30 years.
Interest rates come in two types: fixed or variable. A fixed interest rate will stay the same over the current term of the mortgage, often 3 to 5 years, and a variable rate can increase or decrease over time.
Traditional mortgages are only taken out to assist with the purchase of a property, and do not offer funds for other uses. This type of loan is a long term commitment that uses the newly purchased property as collateral. This means that if the borrower fails to make payments on time, after a certain period the lender can claim the property and resell it to gain back their loaned money.
What is a Home Equity Loan?
A home equity loan allows a current homeowner to unlock some of the equity in their home, which means they will be loaned a portion of the value of their home. Whether you are still paying off your traditional mortgage or have paid it in full, you can take on a home equity loan (also known as a second mortgage) in order to gain access to funds that you can use for renovations, family, etc. A home equity loan also uses the property as a collateral.
The value of your home equity loan is calculated by looking at the value of your property and the amount owing on your existing mortgage. For example, if your home is worth $400,000 and you owe $100,000 on your traditional mortgage, you have $300,000 in equity.
Depending on your financial situation, lender, and credit profile, you could borrow up to 80-85% of that equity amount. Similarly to a traditional mortgage, home equity loans are paid monthly, and they almost always include fixed interest rates.
A home equity loan should not be confused with a HELOC, or home equity line of credit. While a HELOC is another way to unlock some of the equity in your home to use the funds for a variety of purposes, it does not use your home as collateral for the loan.
What are the Differences?
Now that you know how a traditional mortgage and a home equity loan works, let’s look at some key differences between the two:
Homebuyers vs. Homeowners
One main difference between the above loan types is that traditional mortgages are for those who are buying a property or refinancing their mortgage, while home equity loans are for existing homeowners who wish to access a portion of the value of their home. A new homebuyer cannot use a home equity loan instead of a mortgage in order to fund the purchase of a new home.
Since home equity loans are often referred to as ‘second mortgages’, they carry a greater risk for the lender. This is because in a foreclosure situation where the collateral is seized and sold, it is often the first mortgage lender who is paid in full first.
Due to this higher risk, interest rates are often higher for home equity loans than mortgages. That being said, the rates are usually lower than with other types of loans that are not secured against your home.
Use of Funds
When you take on a traditional mortgage, those funds are specifically dedicated to paying for the purchase of a property. When you take on a home equity loan, you have much more flexibility for how you use those funds.
Many people opt for this loan option to cover big expenses such as other debt, medical expenses, schooling expenses, or renovations. If you need help understanding the world of loans, or are looking for more information relating to first or second mortgages, contact a mortgage broker near you.