Should You Choose a Closed-End Second Mortgage (CES) or a HELOC?

What’s better? A closed-end second mortgage (CES) or a home equity line of credit (HELOC)? Both leverage your home’s value for a lower interest rate compared to other types of borrowing. Let’s see how these two second mortgage loans work.

How Does a Closed-End Second Mortgage Work?

A closed-end second mortgage (CES) works like a personal loan.

Homeowners borrow:

• a lump sum of money

• at a fixed interest rate

• and make fixed payments

• over a fixed period of time

So why not just get a personal loan? Because a closed-end second mortgage taps your home equity as collateral for the loan. With your home’s value providing security for the loan, lenders can offer much lower interest rates — sometimes rates that are a fraction of a personal loan’s rates.

How Does a Home Equity Line of Credit (HELOC) Work?

A home equity line of credit resembles a credit card, but one that’s backed by your home equity.

Borrowers open the credit line and then draw funds from the credit line as needed. As with a credit card, a HELOC’s balance changes from month to month as the borrower draws and repays money. Because the balance changes, the HELOC’s payment amount will change, too.

And, the HELOC’s interest rate will typically fluctuate with the market. On average, HELOC interest rates are much lower than credit card rates because — like a closed-end second mortgage — the HELOC uses home equity as collateral.

CES and HELOC Pros and Cons

First, a con for both CES and HELOC: If you default on the loan, the lender could foreclose on your home. Before finalizing any type of second mortgage loan, make sure you can afford its payments. Let’s consider the other pros and cons of these second loan products:

Closed-End Home Equity Loan Pros and Cons

Home Equity Line of Credit Pros and Cons

When to Use a CES Instead of a HELOC

Closed-end second mortgages are simple and predictable. On Day 1 you’ll know how much interest you’d be scheduled to pay throughout the life of the loan.

Because of this, CES loans work well for:

• Debt consolidation: If you’re struggling with high-interest personal loans and credit card balances, a closed-end second mortgage could help calm the storm by creating a single, fixed monthly payment at a lower interest rate

• Large, one-time projects: Closed-end loans work to finance expensive kitchen or bathroom renovations or other one-time expenses like a new roof or new HVAC system

• Other one-time expenses: A CES loan excels at financing one-time expenses such as college tuition or the down payment on a second home

• People who may overspend: A CES’s fixed-and-final loan amount can help prevent overborrowing later

Borrowers can use the money they borrow through a home equity loan any way they want. Borrowers who spend the money on home renovations or expansions could write off the loan’s interest at tax time.

When to Use a HELOC Instead of a CES

A HELOC’s flexibility gives it some advantages over a CES. Borrowers can draw funds when needed and make payments based on the loan’s current balance. Some HELOCs feature an interest-only payment during the early years of the loan, which lowers the monthly payment.

This flexibility makes HELOCs great for:

• Extended projects: The same HELOC could be used to finance a kitchen remodel this year, paid off over the next couple years, and then used again to finance bathroom renovations

• Projects with uncertain budgets: Not sure whether to borrow $30,000 or $50,000? A HELOC doesn’t commit borrowers to one loan amount — just a maximum credit limit

• A source of emergency funds: Some homeowners open a HELOC but never draw funds unless, say, the HVAC finally dies or there’s another unexpected project that needs fast funding

• Temporary borrowing: Some investors use a HELOC to finance upgrades to a home they plan to sell. Then, they pay off the HELOC when the home sells. The HELOC’s interest-only payments and lower closing costs lower upfront borrowing costs

Typical HELOCs allow withdrawing and repaying as needed for up to 10 years. Then, the HELOC’s remaining balance converts to a closed-end loan with fixed payments.

Best of Both Worlds: Lockable HELOC

Some lenders let you lock in a portion of your HELOC at a fixed rate. This gives you the fixed interest rate and predictability of a CES while allowing you to keep a portion of the loan available for additional borrowing.

For example, you get a $100,000 HELOC. You draw $50,000 for a renovation project. You lock in the borrowed $50,000 at a fixed rate and payment while having another $50,000 available to draw on as you need it. Ask your lender about their fixed/floating HELOC options.

What HELOCs and CES Loans Have In Common

HELOCs and CES loans are second mortgages. This means they won’t replace the existing primary mortgage on the home. Instead, borrowers keep making their primary mortgage payments while adding a second monthly payment for the CES or HELOC. This is a big plus if you have a low fixed interest rate on your primary home loan — or if you’ve paid off most of the primary mortgage already. You can stay on schedule with that loan while opening a new loan to access equity.

Here are some other things to know about second mortgages before applying for a CES or a HELOC:

You’ll Need Equity to Back the Loan

Both types of second mortgages work only when you have enough equity to back them up. Equity is the paid-off part of your home’s value. For a home with a value of $300,000 and a primary mortgage balance of $100,000, the homeowner would have $200,000 in equity.

That said, borrowers typically can’t access all of that equity with a second mortgage. Most lenders won’t allow debt on the home to exceed 80 to 85 percent of the home’s value. Lenders measure this debt level through combined loan-to-value ratio, or CLTV.

For example, 80 percent of a $300,000 home equals $240,000. To maintain a CLTV of 80 percent, debt on the home shouldn’t exceed that amount. Even though the homeowner has a first mortgage of $100,000, the lender would cap a home equity loan at $140,000. That way, the primary mortgage ($100,000) and the second mortgage ($140,000) will not exceed 80 percent ($240,000) of $300,000.

However, there are a few 100% HELOC lenders out there, so check with your local credit union and other smaller lenders.

Approval Also Depends on Borrower’s Credit and Income

Equity alone isn’t enough. Like a first mortgage lender, a second mortgage lender will check the borrower’s credit score and debt-to-income ratio (DTI) during the underwriting process. Second mortgages tend to be riskier for lenders. An ideal second mortgage borrower will have a FICO score of 680 and a debt-to-income ratio of 43 percent, but these aren’t absolute limits.

Some lenders have leeway, especially when borrowers aren’t maxing out their available equity with the loan. Shopping around for the best fit can lead to the best approval odds.

The Second Loan Requires a Lien

As part of the closing process, second mortgage lenders will place a lien on your home. The lien gives the lender the legal right to force the sale of your home to pay off the money you borrowed. Lenders can exercise this right when borrowers default on the loan.

If this worst-case scenario happened, the primary mortgage lender would be paid off first. Then the second mortgage company would claim funds from whatever remained from the sale’s proceeds. The lien gives the lender the security it needs to loan money at lower interest rates compared to unsecured borrowing like personal loans and credit cards.

HELOC and CES FAQs

Can I have a CES and a HELOC?

Yes, it’s possible. One of the two second mortgage lenders would have to accept a third lien position. You’d also need enough equity to back all of the loans. The same slice of home equity can’t back two different loans.

Some lenders even let you lock in a portion of your HELOC at fixed terms, leaving the rest available to borrow. Technically, it’s one loan, so you don’t need a third lien on the home.

Should I use my first mortgage company for a second mortgage?

If your primary lender can offer the best deal on a second loan, it’s fine to use the same lender for both loans. Your primary loan servicer may call to offer you a second mortgage.

After all, this lender knows as well as anyone how much equity you have. But most borrowers find the best deal by shopping around for lower rates and fees.

Can I write off the second mortgage loan’s interest?

Yes, if you use the loan’s proceeds to pay for improvements to the home. Using the money any other way — to buy a car, to pay tuition, to consolidate consumer debt, for example — won’t qualify for the mortgage interest tax deduction. And only taxpayers who itemize their deductions (rather than claiming the standard deduction) can write off mortgage interest.

How can I use money from a second mortgage?

Borrowers decide how they’ll use money from a second mortgage. Lenders often ask what the purpose of the loan is; borrowers should answer honestly.

Equity is Hard-Earned. Use it Wisely

You built the home equity by making payment after payment on your primary mortgage. Now, by using a closed-end home equity loan or a home equity line of credit, you’re ready to benefit from the hard work.

The smartest homeowners do two things:

• They use their equity to build a stronger future rather than to pay for a vacation or other temporary needs.
• They shop around to find the best deal on their HELOC or CES loan, comparing rates as well as fees.