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The interest rates I see advertised for home equity loans are typically a little higher than the rates for mortgages used for a home purchase. Why is this? Is the reason because a home equity loan is basically a second mortgage, so it is riskier than a first mortgage on a property?

Relatedly, are home equity loan interest rates the same as or lower than mortgage rates if you take out the home equity loan against a property that you own free and clear, rather than one that still has a mortgage on it?

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Home equity loans are generally subordinate liens. Mortgages are generally first position liens. In the event of a short sale or foreclosure, the first position lien gets paid off first, and then the subordinate (second/third/fourth/etc) position one. So therefore home equity loans are more risky.

Also, the application requirements are much simpler and underwriting guidelines are more lenient in terms of granting home equity loans compared to mortgages which tend to follow Fannie/Freddie guidelines.

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home equity loans are typically a little higher than the rates for mortgages used for a home purchase. Why is this? Is the reason because a home equity loan is basically a second mortgage, so it is riskier than a first mortgage on a property?

Given all other things being equal;

A traditional mortgage, i.e. getting a loan from bank to buy a house is seen as an act of building asset. Thus the perceived risk from lenders point of view is less. An individual is saving to buy a house.

A Home Equity is seen as someone spending money ... i.e. converting an asset into cash. This means he could be spending beyond his/her means as the Home Equity loan can be used for anything, home improvement, vacation, retiring debts with higher interest rates, or gambling. As the reason cannot be established, there is slight higher risk premium.

In case the Home has a mortgage plus a Home Equity; in case of delinquency; depending on the jurisdiction, the institution holding the mortgage has first right to claim full due followed by the institution lending home equity. Even if both institution are same; the risk has slightly gone up. i.e. generally a mortgage is more riskier for financial institution in initial years even through the LTV is capped at 80%. As property price can crash, before the property is liquidated, the loan can accrue interest that exceed the home value.

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  • +1 for this. Your point about spending money is interesting. When I bought my house I could have put down much more than I did, but I wanted to keep that extra money for other things, which may include home repairs, vacations, and of course gambling. So, I purposely took out a larger mortgage than I needed to at the low tax deductible rate. My point here is that if you're right (and I think you are), then the banks should in theory charge a higher rate to those that take out a mortgage for more than they need to, for the same reason that a HEL is higher risk, but of course they don't.
    – TTT
    Aug 4, 2017 at 15:36
  • @TTT Taking as large a mortgage is fine. That you have savings are added comfort to the bank. Generally mortgage rates are lowest possible lending rates.
    – Dheer
    Aug 4, 2017 at 17:49
  • What I meant was, suppose you put 90% down and mortgage 10%. Then on day 2 you take a HEL out for say, 80% of the equity- the rate on the HEL would presumably be higher than had the mortgage been for 90% to begin with, in part due to your "spending money" argument. I was simply pointing out that maybe it shouldn't make a difference, but it seems that it does.
    – TTT
    Aug 4, 2017 at 19:47
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To add onto Adrian's answer, a HEL could carry a lower interest rate than a mortgage. Putting a HEL in first position, with a short term will generally result in a rate that is lower than the prevailing 15 year.

For example one person I know replaced a 15 year fixed conventional with a 7 year fixed HEL in first position. This resulted in a rate about a half point lower than the prevailing 15 year conventional and had zero closing costs.

The bank was lowering their risk profile and therefore could offer a lower rate.

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    Would the DVer please add a comment as to what is wrong with this answer?
    – TTT
    Aug 4, 2017 at 15:23

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