If you want to borrow money for home renovations, car repairs, medical expenses, or other major expenses, finding the right loan may be challenging. Personal loans and home equity loans are two popular loan options, each with advantages and disadvantages.
Personal loans are easy to access and have a simple application process. However, securing favorable terms requires a strong credit history. On the other hand, home equity loans may be easier to qualify for if you don’t have the best credit and want lower interest rates. But, the application process is more extensive, and you’ll need to use your home as collateral. Before choosing one option over the other, compare the key differences to decide whether a home equity loan or personal loan better fits your financial situation.
- Personal loans can be used for many purposes and can be secured or unsecured. Home equity loans are typically used for significant expenses, such as home renovations, and require your home as collateral.
- Personal loans may be a better fit if you have excellent credit, don’t have much equity in your home, and need money fast. Home equity loans are more suitable for those who want low interest rates, plan on using the money for home renovations, have a lot of equity in their home, and do not need the funds immediately.
Personal Loan vs. Home Equity Loan: Key Differences
How Personal Loans Work
Personal loans are a versatile loan option you can use for different purposes, such as debt consolidation, weddings or vacations, or other major purchases. These loans are typically offered by banks, credit unions, and online lenders.
When you opt for a personal loan, you agree to repay the borrowed amount with interest over a set period, usually 6 months to 7 years. Borrows with good to excellent credit tend to qualify for the best rates and terms, though some lenders may work with borrowers with poor credit.
There are two types of personal loans — secured and unsecured. Secured personal loans require you to put up collateral to take out the loan, such as a car or savings account, whereas unsecured personal loans do not require any collateral. Unsecured personal loans may carry slightly higher interests, and approval is typically contingent on factors like income, credit score, and debt-to-income ratio (DTI).
Personal loan amounts vary, typically ranging from $1,000 to $50,000. While rare, some lenders may extend larger sums up to $100,000 to well-qualified borrowers. Repayment terms may also extend to 10 years or more in some cases.
Interest rates on personal loans are often fixed, although variable-rate options may also exist. The rates can fluctuate widely, from as low as 6% to as high as 36%. Additionally, some lenders impose a loan origination fee of up to 5% of the loan amount, which gets deducted from the received loan proceeds. Certain lenders may also charge a prepayment penalty for early loan repayment.
You can usually submit a personal loan application online, but some lenders may require you to apply at their physical branch. It’s best to shop around and compare different lenders to find the best deal. Key items to review include the interest rate, loan amount, and monthly payments.
Upon submitting the loan application, the lender performs a hard credit check, resulting in a temporary and minimal negative impact on your credit score. Once approved, the lender often disburses the funds directly into your bank account within the next business day.
How Home Equity Loans Work
Home equity loans offer borrowers the ability to secure more substantial amounts of funds compared to personal loans. However, they require you to use your home’s equity — the value of your home minus the remaining amount owed on your mortgage — as collateral. In other words, if you default on your loan, the lender may have a claim over your house.
To qualify for a home equity loan, you will typically need at least 20% equity in your home. Most lenders require a loan-to-value ratio (LTV) of 80% to 85% or higher. For instance, if your home is valued at $350,000 and your mortgage balance is $225,000, your equity amounts to $125,000, approximately 36% of the property’s worth.
Compared to personal loans, home equity loans usually come with substantially lower interest rates, making them a more cost-effective option. Home equity loan rates hover around 8% to 11%, contingent on factors such as your LTV ratio, credit score, and other relevant elements (as of September 2023).
Repayment terms for most home equity loans range between 5 and 20 years, though some lenders may offer extended terms of up to 30 years. During the repayment period, you’ll typically have two monthly payments: your primary mortgage payment and home equity loan payment.
Getting a home equity loan is lengthy and complex. Although you can often initiate the application online, the process generally spans a few weeks, requiring a thorough evaluation of your property. This assessment helps determine the amount you can borrow and the loan terms. You should explore options from the lender holding your mortgage and compare various home equity loan offerings to find the best one for you.
Additionally, similar to a mortgage, you’ll usually have to pay closing costs ranging from 2 to 5% of the loan amount. Because of the closing process, it can take up to 6 weeks or more to receive the funds.
When to Choose a Personal Loan
You Have Excellent Credit
Having excellent credit qualifies you for the best personal loan rates that are competitive with home equity loan rates. Current interest rates vary from 6.99% to 35.99%. If you have multiple credit card balances, you may be able to consolidate debt for a lower cost using a personal loan.
You Don’t Have Much Equity or Don’t Want to Risk Your House
If you are not a homeowner or do not have enough equity in your home, you won’t be able to take out a home equity loan. Most home equity lenders have a minimum LTV requirement. Additionally, if your equity in your home falls below a certain amount on a conventional loan, you may need to pay private mortgage insurance (PMI) every month. On the other hand, most personal loans are unsecured, so you do not risk any of your assets if you default.
You Only Need a Small Amount of Money
If you are only borrowing a small amount, you can save money on closing costs and other fees by taking out a personal loan instead of a home equity loan. Some lenders let you take out as little as $500 or $1,000, whereas home equity loans may have a $10,000 minimum.
You Need The Money Now
If you need money immediately to cover an emergency, moving expenses, or anything urgent, you will get the funds faster if you apply for a personal loan. It can take a few days to a week to get a personal loan, but a home equity loan may take at least a month or longer.
You can also repay the loan more quickly. Repayment terms for home equity loans typically range from 5 to 30 years, whereas personal loans range from 1 to 7 years. While longer repayment terms may come with lower interest rates and payments, you will accrue more interest over time than if you were to pay off the loan faster.
When Not to Choose a Personal Loan
If you need to borrow a significant amount of money, a personal loan may not be enough for your needs. Personal loans typically have a $50,000 loan limit. Plus, if you have bad credit, you may only qualify for the steepest interest rates, which increases your borrowing costs and may make the monthly payment unaffordable.
Home Equity Loans
When to Choose a Home Equity Loan
You Want Low Interest Rates
While borrowing a home equity loan is more complex than taking out a personal loan, the interest rates are usually much lower. This means your monthly payment will be smaller, and you will pay less for borrowing money.
You Want to Make Home Renovations
If you use a home equity loan to remodel or renovate your home, you may be able to deduct the interest on the loan from your federal income tax. In other words, you can get a tax break for making improvements to your home.
You Have a Lot of Equity in Your Home
If the value of your home has risen significantly since you first bought it, or you have built up a large amount of equity in your home, you may be able to borrow several hundred thousand dollars. That’s far more than what you can borrow with a personal loan.
Your Credit Isn’t Great
If you don’t have the best credit, you may not be able to qualify for a personal loan, or if you do qualify, it may be costly. A home equity loan can be easier for people with poor credit to qualify for because it is secured by their home. While you may not get the best rates, you can still borrow the money you need.
You’re Not In a Rush
Home equity loans usually require additional steps before you can get the money and come with long repayment terms. If you are not in a rush to get the funds and want to use the money for home renovations or other non-emergency purposes, a home equity loan could be a good fit. Additionally, you can repay them over a longer period, meaning you’ll have lower monthly payments.
You Can Repay The Loan
Taking out a home equity loan is essentially a second mortgage payment, so make sure you can confidently repay the loan. You should only borrow a home equity loan if you are comfortable with the repayment terms.
Your Home Value is Rising
If home values in your area are rising, you don’t need to worry about your home equity loan. But, if home values are decreasing, a home equity loan may put you in a tough situation. There’s a possibility you could end up with an underwater mortgage, where you owe more money than the home is worth. That makes it difficult to sell your home, especially while you’re still making two loan payments.
When Not to Choose a Home Equity Loan
If you don’t have a ton of equity in your home, it doesn’t make sense to take out a home equity loan. Additionally, if money is tight and you are struggling to pay your bills, you could risk losing your home if you miss a payment. The closing costs and interest will also eat into your finances, making it more difficult for you financially.
Alternative Borrowing Options
Home Equity Line of Credit (HELOC)
A home equity line of credit works similar to a credit card. It is a revolving line of credit you can use for almost any purpose. Like with a home equity loan, you are borrowing against the available equity in your home, so they tend to have lower interest rates, and the interest may be tax deductible.
You can borrow up to 85% of the value of your home minus the balance on your mortgage. When you apply, lenders will review your credit score, monthly income, debt-to-income ratio, and credit history.
Throughout the draw period, usually 10 years, you can borrow as much as you need up to the credit limit. When you pay back the money borrowed, you can replenish the available funds you can borrow. You will start paying off the debt at the end of the draw period, typically over 20 years.
Most HELOCs have variable interest rates, meaning the price you pay to borrow money can fluctuate over the loan term. When interest rates go up, so does your payment. This can make the overall financing costs hard to budget for.
Cash-Out Mortgage Refinancing
A cash-out mortgage refinancing is when you replace your existing home loan with a bigger mortgage with new repayment terms and monthly payments. This process allows you to keep a single monthly payment and comes with a new interest rate and repayment length. The excess proceeds are typically given to you at closing, which you can use at your discretion.
If you want to tap into your home’s equity and also change your repayment terms, cash-out refinancing can be a good strategy for you. However, if your mortgage currently has a low interest rate, you’ll need to sacrifice it to refinance. With mortgage rates hovering around 7%, it may not make much sense to refinance at this time because you will get less favorable terms.
Credit cards carry many benefits, including cashback, frequent flyer miles, 0% APR introductory periods, and secondary travel perks. They are convenient and can act as a safety net for emergencies.
Depending on what you need the money for, using a credit card can be a smart alternative to taking out a personal or home equity loan. For example, if you have an unexpected expense, you can open a credit card with a 0% intro APR, meaning you do not need to pay interest on your loan during that time.
But, credit cards typically have high interest rates. If you can’t make your payments, your debt can quickly snowball. Additionally, if you miss a payment or make a late payment, that can damage your credit. Some credit cards also come with high annual fees. For example, the American Express Gold card has a $250 annual fee.
If you plan on using a credit card, ensure you can pay off the balance on time and in full each month. While I use credit cards for all my purchases, I always pay off my entire balance by the end of the billing cycle every month to avoid accruing interest charges.
The Bottom Line
Choosing between a personal or home equity loan depends on your financial situation. Before applying for the loan, compare all your loan options, interest rates, fees, and other factors.