However, are you aware of all the loan options available to you? Instead of preoccupying yourself with the onerous task of figuring out the difference between a home equity loan, a home loan, or a mortgage on your own, read through to understand the simplified concepts.
Once you know all your available options, choosing the right loan becomes easy.
What Is a Mortgage?
A mortgage is not exactly a loan. It is a security instrument or contract that is signed between the lender (mortgagee) and the borrower (mortgagor). A lien is created on your property. As soon as you settle the outstanding dues, your property becomes free of lien.
With a mortgage, the lender has a right to claim your property if you fail to repay your debts in accordance with the terms of the agreement.
What Is a Home Loan?
A home loan is a credit facility which you secure with your home. The lender has the right to auction off your property (collateral), in the event you fail to return the borrowed amount, to compensate itself for the loss.
Like a mortgage loan, a home loan is usually an instalment loan on which a fixed rate of interest is applied for the initial years. In some cases, a variable rate of interest pegged to a government- or lender-determined index may also apply.
The US Treasury bill rate, the prime lending rate reserved for preferred borrowers, or the bank’s board rates are often used as base components of variable rates on which a surcharge is added by the bank.
You may be able to borrow up to 60% to 80% of the purchase price or the appraised value of your home through a home loan.
What Is a Home Equity Loan?
A home equity loan is often referred to as a “second mortgage” in the US. It is usually taken when the value of your property has appreciated substantially. These are usually fixed instalment loans.
Your home equity is defined as the difference between the fair market value of your property and the outstanding debts on it. In the US, you may be able to borrow anywhere between 85% and 95% of the equity value of your home.
For example, if the current value of your property is US$500,000, and you have a total debt of US$200,000, the equity of your home is US$300,000. Some lenders may allow you to borrow up to US$285,000, which translates to 95% of your home equity.
Some lenders may also use a measure called the loan-to-value ratio (LTV) to determine the maximum borrowing amount. The LTV, expressed as a percentage, is defined as the ratio of the current value of your home to the outstanding debt.
If you have multiple mortgages on your home, the combined-loan-to-value (CLTV) would be used as a measure instead of LTV.
The tenure of all the three types of instruments discussed above can go up to 30 years. Since repayments have to be made in fixed instalments, appropriating a budget becomes easier.
Should You Apply for a Mortgage Loan or a Home Equity Loan?
A mortgage loan/home loan, also called the first mortgage, is usually taken with the purpose of buying a home.
A home equity loan is generally taken for the purpose of home remodelling and improvement, bill consolidation, or for clearing the debt on your home loan.
Since you can apply for a second mortgage loan at the same time as a home loan, you may also use a home equity loan to make the full down payment on your home, which could be a substantial amount.
In the US, if you make a down payment of less than 20% of the purchase price, you may have to additionally invest in a private mortgage insurance plan. As you would have guessed, it doesn’t come cheap. Moreover, the premium for this insurance has to be made along with your loan repayments, increasing your liabilities.
By taking a home equity loan at a lower rate of interest, you may be able to avoid this costly insurance.
Home Equity Loan vs Cash-Out Refinancing
A home equity loan is usually a second mortgage loan that charges a lower rate of interest.The speed of approval is also faster than other loans. However, you have to maintain two separate loans and pay interest on both.
Cash-out refinancing typically leads to a bigger loan. It pays for your current mortgage and your additional cash needs. The quantum of a cash-out loan is larger than the outstanding balance on your mortgage.The extra cash may be used for any purpose. Since the interest rate is quite low, you may also notice a change in the monthly cash outflow.
Effect of New Tax Deduction Rules on Mortgage Loans and Home Equity Loans
This year, as per the Tax Cuts and Jobs Act of 2017, homeowners will only be able to claim a tax deductible of US$750,000 on interest paid on the combined debt on all properties. The previous deductible limit was US$1 million.
While this won’t affect the existing mortgages and possibly the new ones, according to an IRS advisory, this tax deductible of US$750,000 a year on interest paid can only be enjoyed if a home equity loan or line of credit is taken for the purpose of building or improving your home. This means you won’t enjoy deductions on your tax liabilities if you use a home equity loan for any other purpose like paying for your education loan or your credit card debt.
Moreover, according to the IRS, deductibles can only be enjoyed on your primary property and your second property, provided the value of the loan doesn’t exceed the cost of your properties.
A home equity loan can be a smart choice when you are faced with a cash crunch, as it lets you benefit from the appreciation in value of your property. However, the type of loan you finally choose for your home, should strictly depend on your objective.