Source: Investopedia —
Buying a home is one of the most significant investments you can make. For most home buyers, that large of a purchase requires financing in the form of a mortgage. But once you have made your purchase, your mortgage payments start working for you as you build equity in your home. Home equity can be leveraged by taking out a home equity loan, also known as a second mortgage.
These two financial tools are very similar, but there are differences, especially in repayment terms. Let’s find out the similarities and differences.
- Home equity loans and mortgages both use property as collateral for a secured loan.
- Home equity loans are typically fixed interest rates over a period of five to 30 years.
- Mortgages can be fixed rates or adjustable rates.
What Is a Mortgage?
A mortgage is an installment loan used to purchase a home. There are several different types of mortgages, including conventional loans backed by banks, and loans backed by the Federal Housing Administration (FHA), U.S. Department of Veterans Affairs (VA), and U.S. Department of Agriculture.
Mortgage loans can have either fixed interest rates or adjustable rates. Adjustable-rate mortgages (ARM) adjust their rates on a set schedule. For example, a 5/1 ARM offers a fixed rate for the first five years. After that, the rate will adjust yearly until the loan is paid. There are many different types of ARMs, so make sure you understand the terms of your agreement.1
You must have at least 20% equity in your home to be approved for a home equity loan.2 If you have an interest-only loan, your first several years may not build any equity to borrow against in the future. Equity can still be built by increasing the value of your home, either through improvements or market movement.