What Is the Difference Between a HELOC and a Second Mortgage?

Homeowners frequently leverage their home equity to address various financial requirements, whether for significant expenses or unexpected needs. A home equity line of credit (HELOC) and a home equity loan, often termed a second mortgage, represent two common financial instruments for accessing this equity. This article clarifies the distinctions and shared attributes of these financing options, providing a clear understanding for those considering utilizing their home’s value.

Understanding a Home Equity Line of Credit (HELOC)

A home equity line of credit (HELOC) functions as a revolving line of credit, similar to a credit card, secured by home equity. This allows a homeowner to borrow funds up to a predetermined credit limit as needed, rather than receiving a single, upfront lump sum. The flexibility of a HELOC means that borrowers can draw funds, repay them, and then draw again, as long as they remain within their approved credit limit and during the designated draw period.

HELOCs are structured with two distinct phases: a draw period and a repayment period. The draw period typically spans between 5 to 10 years, during which borrowers can access funds up to their credit limit. During this phase, payments are often interest-only, meaning the borrower primarily covers the interest accrued on the borrowed amount.

Following the draw period, the HELOC transitions into the repayment period, which commonly lasts from 10 to 20 years. In this phase, the borrower is no longer able to draw new funds. Instead, they are required to make principal and interest payments on the outstanding balance, designed to fully amortize the loan. Interest rates on HELOCs are predominantly variable, meaning they fluctuate based on a specified financial index, such as the prime rate.

The variable interest rate means monthly payments can change over time, potentially increasing or decreasing depending on market conditions. Accessing funds from a HELOC is typically straightforward, often done through checks, a debit card, or electronic transfers. This structure offers adaptability for ongoing financial needs, but introduces payment uncertainty due to rate fluctuations.

Understanding a Home Equity Loan (Second Mortgage)

A home equity loan, commonly referred to as a second mortgage, provides a lump sum to the borrower at closing. This loan is secured by the equity in the borrower’s home, existing as a separate loan distinct from the primary mortgage. Unlike a revolving line of credit, the entire approved loan amount is disbursed in one transaction, giving immediate access to the full sum.

The interest rate for a home equity loan is typically fixed for the entire loan term. This provides predictability in monthly payments, as the principal and interest payment amount remains constant throughout repayment. Loan terms commonly range from 5 to 20 years.

Repayment of a home equity loan begins immediately after funds are disbursed. Borrowers make regular, fixed monthly payments that include both principal and interest, designed to fully amortize the loan. Once the lump sum is received, no additional funds can be drawn from that specific loan.

This financing option is often preferred by homeowners who require a specific amount for a one-time expense. Examples include consolidating debt, funding a large home renovation project, or paying for educational expenses. The fixed interest rate and predictable payment schedule offer financial stability for budgeting.

Key Differences

The fundamental distinction between a HELOC and a home equity loan lies in how funds are disbursed. A HELOC provides a revolving line of credit, allowing borrowers to draw funds as needed up to a set limit over a specific draw period. Conversely, a home equity loan delivers a single lump sum at closing.

Interest rate structures also represent a significant divergence. HELOCs typically feature variable interest rates, which means the rate can fluctuate based on a benchmark index, leading to changing monthly payments. Home equity loans generally come with fixed interest rates, ensuring consistent and predictable monthly payments for the entire loan term.

Access to funds varies considerably. With a HELOC, borrowers can repeatedly access and repay funds during the draw period, offering flexibility for ongoing or unpredictable expenses. In contrast, a home equity loan provides a one-time disbursement, and once funds are received, no further amounts can be drawn.

The repayment structure is another differentiating factor. HELOCs often feature an interest-only payment period during the draw phase, followed by a principal and interest repayment phase. Home equity loans require consistent principal and interest payments from the beginning of the loan term, leading to steady principal reduction.

Shared Characteristics

Despite their operational differences, both home equity lines of credit and home equity loans share several fundamental characteristics. Both financial products are secured by the borrower’s home equity, meaning the property serves as collateral. This makes them “second mortgages,” subordinate to the primary mortgage.

Both HELOCs and home equity loans involve placing a lien on the property, typically in a second position behind the primary mortgage. This lien grants the lender a claim on the property in the event of default.

Closing costs are generally associated with both types of home equity financing, similar to those encountered with a primary mortgage. These costs can include appraisal fees, origination fees, and title search fees, typically ranging from 2% to 5% of the loan amount or credit limit. These fees are often paid when the loan or line of credit is established.

Interest deductibility is a shared characteristic. Interest paid on both HELOCs and home equity loans may be tax-deductible if funds are used to buy, build, or substantially improve the home that secures the loan. This deduction is subject to IRS guidelines and limitations, including a combined acquisition indebtedness limit of $750,000 for loans taken out after December 15, 2017.

Both financing options ultimately reduce the available equity in the home as funds are utilized. When a borrower draws on a HELOC or receives a home equity loan, the amount of unencumbered equity decreases, impacting the homeowner’s net financial position.

Citations:

Internal Revenue Service, Topic No. 504.