What’s the difference between a mortgage and a HELOC? When should you use each? What does HELOC even stand for? And where does a home equity loan fit into all this?
Mortgages and second mortgages (HELOCs and home equity loans) are confusing. They’re all tied to homeownership, so that’s the common ground. But they’re used for slightly different purposes, with slightly different criteria.
Are you looking to buy a first home? Do you own a home and want to do renovations? Need cash for a second home? You may need to borrow money in different forms for each of these. Read on to learn more about mortgages, HELOCs, and home equity loans, what they’re each used for, and how they compare.
A mortgage is an agreement with a bank or financial institution, where they pay for the majority of your home purchase and you agree to pay them back over time. It’s a legally-binding agreement that requires you to pay back the borrowed money plus interest, or risk losing possession of your home. Say you want to buy a house that costs $500,000 and you have $100,000 saved, you’ll need to borrow a mortgage of $400,000 to buy the house.
This form of conventional mortgage is probably what you think of when you think of mortgages. It’s what almost everybody uses to buy their first home. Mortgage brokers can help you find the best financing conditions to suit your homebuying needs, and then the lender you choose will put up most of the cash to help you buy your home.
To qualify for a mortgage you generally need three things: a downpayment, a steady job, and a good credit score. Your downpayment is the amount of money you put towards the house yourself – in Canada this needs to be at least 5% of the purchase price if you’re going to occupy the home, or a minimum of 20% if it’s going to be a rental property. If you plan to live in the home and you pay less than 20% you also need to pay for mortgage loan insurance as the lender will be carrying more of the risk.
Once you qualify, you’ll need to settle on your mortgage term and amortization. The amortization is the full length of the loan for all your repayments to be made. This is often 25 or 30 years. Your mortgage term is the amount of time you’re committing to your current mortgage rate. Terms are most typically set between one to 10 years, but are most commonly five years. The mortgage rate is the interest charged on the mortgage and can be either fixed (the same interest rate for the length of the mortgage term) or variable (meaning the rate can fluctuate up or down based on a benchmark rate).
Ok, so we know about mortgages – it’s how you usually buy your first home. But what comes next? What about once you already own a home but you want an additional mortgage product for renovations, or to buy a second home, or for something else? That’s where second mortgages come into play.
The two common types of second mortgages are HELOCs and home equity loans. Both leverage the equity you have built up in your property. A bank or lender would assess the value of your home and if you’ve paid down some of your mortgage or your property value has increased, the equity would be the difference between what you still owe on your mortgage and the value of your home. So, say you owe $200,000 on your home and it’s valued at $500,000, you’d have $300,000 in equity. You could then take out a loan (a secondary mortgage) against that equity.
It’s important to note with second mortgages that your home is your security on the loan – so, if you default on the loan, you could lose your home.
A HELOC (home equity line of credit) is a type of second mortgage. You typically get a second mortgage, as the name suggests, once you already own a home.
Somewhat different to other mortgages, a HELOC functions almost like a credit card. So, instead of receiving a lump payment from the lender, a HELOC approves you for a set limit of funds, which you can draw from as and when you need. This means you only take out the funds you need and are charged interest only on the amount you’ve used. If you have a HELOC but don’t spend any of the approved funds, you won’t owe any interest or principal payments.
The line of credit stays open until the loan period ends. HELOCs have two parts to them: a draw period and a repayment period. If we consider a 30-year loan, the draw period might last 10 years. During the draw period, you’re able to withdraw funds. You still need to make payments during the draw period if you spend, but these will typically just be interest. Then, the repayment period would last another 20 years. During the repayment period you can’t draw funds anymore. HELOC interest rates are almost always variable.
In Canada, you’re allowed to borrow up to 65% of the appraised value of your home through a HELOC, minus what’s left on the mortgage. So, if your home is valued at $500,000 and your current mortgage still has $200,000 on it, you would be able to borrow $125,000 (65% of the $500,000 value of your home is $325,000, minus the $200,000 you still owe on your mortgage).
Home equity loans
A home equity loan is another kind of second mortgage. Like a HELOC, it’s something you get once you already have a mortgage and it’s based on the equity in your home. Where a HELOC is more like a credit card in that you have a limit and can spend and pay it off as you go, a home equity loan is more like a conventional mortgage because you receive the full loan as a lump sum and repayments begin immediately.
With a home equity loan you can borrow up to 80% of the appraised value of your home, minus the current balance on your mortgage. Rates are usually fixed and the regular payment amounts are fixed over the life of the loan, with each payment paying off interest plus some of the principal. The term of a home equity loan is usually up to 30 years, as approved by the lender.
What’s right for you? Mortgage, HELOC, or home equity loan?
A conventional mortgage is ideal if you’re buying your first home. A mortgage can also be a good option if you’re buying a subsequent property and have the cash available for the downpayment (rather than taking equity out of the first home). Of the three mortgage options in this article, a conventional mortgage will offer the best rates as it’s the lowest risk to a lender.
A HELOC might be right for you have equity to use and you have unspecified spending ahead of you, where you’re not sure how much you need or when you might need it. Because a HELOC gives you access to credit you can borrow and repay as needed, it’s handy for expenses and spending that arises over time. With a HELOC you can borrow some, repay it, borrow more, repay it, for as long as the draw period lasts.
Home equity loan
A home equity loan could be a good choice if you have a set cost you need to borrow, for example to undertake some home renovations that have already been priced. With this type of second mortgage, you’re given the amount you need in one lump sum and you’re guaranteed set repayments over the whole course of the loan. You’ll be able to plan for exactly the same repayment cost every month.
Mortgages and second mortgages are used for similar but different things. Most people will likely need a conventional mortgage to buy their first home, but second mortgages leveraged from your home equity can serve different purposes. If you’re pursuing either a HELOC or a home equity loan, you need to consider what you need the money for and when you’re going to need it. Your decision will likely come down to your needs.
Sam Boyer spends, invests, budgets, and writes. He enjoys writing about things he wishes he’d learned earlier — like spending, investing, and budgeting. A journalist originally from New Zealand, Sam has written extensively about consumer affairs, insurance, travel, health, and crime.