Home Equity

Mortgage vs HELOC vs Home Equity Loan: A Guide

August 4, 2023

Whether you’re looking to fund your next real estate purchase or access the equity in your home, you might be considering the merits of a mortgage vs home equity loan, or even a home equity line of credit (HELOC).

Mortgages, home equity loans, and HELOCs are three distinct lending products with their own advantages and drawbacks. This guide breaks down all three in detail to help you choose the best option for your financial needs. We’ll also touch on additional financing options, like residential sale-leaseback agreements.

What is a Mortgage?

A mortgage is a loan to purchase a home. When it comes to funding a home purchase, mortgages are by far the most common financing tool buyers use to access the capital they need. That said, there are important aspects to consider about mortgages:

They’re not uniform – Mortgage lenders charge interest rates based on your creditworthiness and other financial factors (like economic conditions and the Federal Reserve’s chosen interest rate).
They’re not always approved – Mortgage loan applicants must meet specific requirements to qualify for a loan—their creditworthiness, current debt, and credit score all play a role in the approval process.

They won’t cover all of your costs – Your mortgage will cover the purchase price of your home less the down payment, escrow, earnest money, and some closing costs. But, it won’t cover the costs of regular repairs and maintenance, utility bills, homeowners insurance premiums, or property taxes.

When working with a mortgage, remember that your home acts as the collateral. If you stop making payments (i.e., default on your loan), your lender can repossess your home and sell it to make back the funds they invested in your loan.

Advantages of a Mortgage

There are certain advantages to taking the mortgage route when purchasing a home:

Mortgages are generally considered low-risk to borrowers—they’re funded by highly stable financial institutions, and the approval process typically confirms the borrower’s ability to repay the loan amount over time.
Mortgages can be flexible, and you can adjust your terms over time (i.e., you can refinance your home).

Mortgages are also the most straightforward lending solution for buyers, as there is a wealth of information about them available publicly.

Drawbacks of a Mortgage

Mortgages have a few drawbacks to consider, too:

They’re long-term – Most mortgages stipulate repayment plans that last for decades. The longer your term, the lower each monthly mortgage payment will be, and the more you’ll pay in the loan’s lifecycle. You can pay off your loan faster than your contractually obligated term, but purchasing a home with a mortgage is typically the beginning of a long-term financial commitment.

They impact your debt-to-income ratio – Lenders use your debt-to-income ratio to determine your ability to repay a loan before you’re approved. If you plan to purchase a second home, get a loan for a new car, or apply for a new credit card after you take out a mortgage loan, you might not make enough income to qualify for future loans (until you pay off your mortgage).

All things considered, mortgages are generally a low-risk, smart investment. With each interest payment, the asset (your home) should be generally appreciating in value, offsetting your mortgage costs.

When is a Mortgage a Good Idea?

A mortgage is a good idea for potential homebuyers who:

Have the financial ability to repay the loan throughout the entire term
Are financially responsible enough to make each monthly mortgage payment in full and on time
Can afford the non-mortgage costs associated with home ownership, like:
- HOA fees
- Property taxes
- Homeowners insurance
- Utilities
- Routine maintenance and repairs

While mortgages are considered low-risk, it’s critical to recognize that qualifying for a mortgage doesn’t mean you can afford that mortgage. Changes to lending regulations after the 2008 real estate crash offer additional protection for consumers, but these don’t act as guarantees. Homeowners are ultimately responsible for determining whether or not the mortgage is affordable.

What is a HELOC?

A home equity line of credit (HELOC) is a loan product for people who already own a home. A HELOC is a revolving, constantly available borrowing tool that homeowners can use to:

Consolidate high-interest debt (e.g., credit card debt, student loans, or medical debt)
Pay for major property repairs, renovations, or upgrades
Create a financial safety net ahead of a major life event (like switching careers)

Since a HELOC is revolving, you’ll have access to the credit offered throughout the term period. But remember that financial institutions will only issue a HELOC that’s:

Less than the total equity you have in your home—your remaining home value is already leveraged as collateral for your primary mortgage loan

Correlated to your home’s loan-to-value ratio—if you have upside-down equity, your HELOC amount might be substantially lower than your existing equity

Advantages of a HELOC

HELOCs can be advantageous loan products for a few reasons:

They’re revolving – If you open a $10,000 HELOC for 10 years, use the entire $10,000 to pay for a new roof, and repay the $10,000 in 5 years, you can still access that $10,000 for other purchases until the end of the term.

They generally correlate to your equity – Unless you’re upside-down, you can generally expect your line of credit to be worth most of your equity at the time of application.

Draw periods and repayment periods are separate – In the hypothetical above, you’d still have 5 years remaining to borrow against your HELOC. Once the 10-year term is up (the draw period), your repayment period begins. You don’t have to pay back the entire loan within your draw period.

Drawbacks of a HELOC

A HELOC loan isn’t the right choice for everyone, and there are some drawbacks to consider:

Making two payments – If your HELOC repayment period begins before your primary mortgage term ends, you could be stuck making payments on both loans every month until you’ve completely repaid one of them. This simply might not be affordable for some homeowners.

Value restrictions – Lending amounts can vary, but HELOC lenders rarely offer a line of credit that represents 100% of your equity.

They’re not free – Like a traditional mortgage, HELOC lenders charge interest rates that correlate to your creditworthiness, the term length, and economic health (e.g., Federal Reserve interest rates).

When is a HELOC a Good Idea?

So is HELOC a good idea? A HELOC loan can be a smart financial decision for people who:

Have sufficient income to pay back both their primary mortgage and the HELOC
Want to access their equity to pay for a major repair, renovation, or upgrade
Need a safety net ahead of a transition that could temporarily impact their income, like:
- Going back to college
- Pivoting to a new career
- Starting a business
- Having a child and taking unpaid family leave

What is a Home Equity Loan?

While they’re similar, a HELOC and a home equity loan are two distinct loan products. While a HELOC leverages your existing equity as collateral for a revolving loan, a home equity loan leverages your existing equity for a one-time loan—you can only use the lent funds once.

This is perhaps most easily explained with a hypothetical:

You’re interested in replacing your home’s roof, and you get an estimate for $20,000.
You have $50,000 worth of equity in your home, but you don’t have $20,000 in cash.
You apply for a home equity loan for the cost of the roof replacement: $20,000.
You receive your loan principal, spend it, and begin repaying your home equity loan.

Home equity loans are sometimes called “second mortgages” because they’re just that: a second, one-time loan that uses your home’s value as collateral. But, in the case of a home equity loan, the collateral is a portion of your home’s value that you already own. Learn more about the differences between a home equity loan vs second mortgage for more info.

Advantages of a Home Equity Loan

There are both pros and cons of home equity loans. Home equity loans can be highly useful loan products because:

They’re low-risk – Since you’re borrowing against equity that you own, you have more control over your risk. As long as your income can support both a primary mortgage and home equity loan repayment, your risk should be relatively low.

They’re one-and-done – As soon as you use the funds lent, your repayment begins. There’s no lingering line of credit to consider in your financial planning.

They have fixed interest rates – Home equity loans typically feature fixed interest rates—interest rates that won’t change during the repayment period.

Drawbacks of a Home Equity Loan

Before you apply for a home equity loan, consider the drawbacks:

Double payments – If you take out a home equity loan while you’re still repaying your mortgage loan, you’ll be making two significant loan payments each month. If your income can’t support this, you simply can’t afford a home equity loan.

They’re not revolving – While applying for a one-and-done loan might simplify some homeowners’ financial planning, others might prefer the advantages of a HELOC’s revolving lending model.

When is a Home Equity Loan a Good Idea?

So is a home equity loan a good idea? Like a HELOC, homeowners can use a home equity loan to:

Fund a significant repair, replacement, or upgrade to their home
Consolidate high-interest debt (like credit card or medical debt)
Pay for a major life transition, like moving a relative to an assisted living facility

Comparing the Three: Mortgages, HELOCs, and Home Equity Loans

Now that you have a clearer picture of all three loan products, let’s compare mortgage vs HELOC vs home equity loans:

Intended applicant – While mortgages are designed for prospective homebuyers to purchase a home, HELOCs and home equity loans are designed for current homeowners.

Purpose – Mortgages are issued specifically to purchase real estate, but HELOC and home equity loan funds can be used to meet a variety of financial needs.

Size and terms – Mortgage loans are almost always larger than HELOCs and home equity loans. They’re also typically paid back over longer terms than their counterparts.

Risk – Mortgages are certainly the lowest-risk financial product of the three, but HELOCs and home equity loans are also generally low-risk (since you own the collateral—your existing equity).

Price – Depending on your lender, the economic conditions when your loan begins, and your creditworthiness at the time of loan origination, all three loan products can be relatively affordable for creditworthy applicants. But, if your income barely covers your primary mortgage payment, a HELOC or home equity loan isn’t a good choice—if your mortgage term doesn’t end before your HELOC or home equity repayment period starts, you’ll be making two major loan payments each month instead of just one.

An Alternative Solution: Residential Sale-Leasebacks

If you’re a homeowner and the options above aren’t compatible with your financial situation, there are alternative ways to get equity out of your home such as a sale-leaseback transaction, also known as a rent-back agreement.

In a residential sale-leaseback, homeowners:

Sell their home to a buyer for fair market value
Use the cash proceeds from the sale to meet their current financial needs
Continue living in their home while leasing it from the new owner
Reserve the option to purchase the home back from the new owner at a later date if they’d like

If you need cash for a major purchase or to eliminate some of your high-interest debt, a sale-leaseback transaction could be a good fit to convert home equity and meet your financial circumstances.

Key Takeaways

Mortgage vs HELOC and mortgage vs home equity loan comparisons can help current and prospective homeowners choose the loan product that best meets their current financial needs.

Homeowners shouldn’t forget about alternative equity liquidation options like sale-leaseback agreements—alternative options like these can help homeowners in unique financial circumstances.

At the end of the day, homeowners should make every effort to choose loan and liquidation products that they can afford, that won’t drastically impact their quality of life, and that support overall improvements in financial health.

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