Learn the difference between a home equity loan and a home equity line of credit. This introduction also explains the best uses for these loans and your legal rights if you change your mind.
The term “second mortgage loan” is not frequently used by lenders anymore. The traditional second mortgage is now more commonly called a home equity loan. A home equity line of credit is also referred to as a second mortgage. Both loans are backed by the equity in your home, but there are differences between them.
Home Equity Loan
The home equity loan is similar to the traditional second mortgage your parents may have had. Equity is the difference between the current market value and the principal balance of the mortgage loan. A home equity loan uses that difference as collateral for a second loan against your home. It doesn’t replace a first mortgage. Because it will be the second debt paid if you default on your loans, it has a higher interest rate than a comparable first mortgage. Most home equity loans have a fixed rate, although some are offered as adjustable rate mortgages. With a home equity loan second mortgage, you receive a lump-sum payment in cash and then repay the loan over a fixed period of time.
Home Equity Line of Credit
A home equity line of credit (HELOC) also uses the equity in your home as collateral. Rather than a fixed sum of money, your lender issues you a credit line with a fixed limit. You access the money by writing checks or using a debit card linked to it. HELOCs have a variable interest rate that is based on the current prime rate plus a percentage. You may borrow funds any time between the issuance of the credit limit and its expiration date, which can be anywhere from three to ten years. Your repayment terms and amounts vary depending on the amount borrowed and current interest rate. Most HELOCs require you to remove an initial sum and not repay it until the line of credit expires. Most also require a minimum withdrawal each time you access the funds.
How to Use a Second Mortgage
Regardless of which type of second mortgage loan you choose, second mortgages should only used to:
Make home repairs
Remodel your home
Pay education expenses for you or your child
Reduce other debts
In other words, a second mortgage should be used to improve your child’s or your financial future. It should not be used for non-real estate investments or purchases of consumer goods like televisions, cars, boats, or other big-ticket items.
Second Mortgage Right of Rescission
You have three business days, not including Saturdays, Sundays, and legal holidays, from the date you sign your home equity loan documents to cancel the loan without cost to you. The loan must be against your primary residence. If you used the same lender as your original loan, then you only qualify for rescission if you increased the amount of your original loan with a cash-out refinance or took out a home equity loan. You can rescind any mortgage refinance or home equity loan within the three day period if you used a different lender.
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