Personal Loan vs. Home Equity Loan: Which Is Better?
Loans, especially personal and home equity loans, can be a good way to pay for a major home project or handle a financial emergency. But before you apply for either type of loan — or an alternative, such as a home equity line of credit — do some research and decide which option best suits your needs.
What Is a Personal Loan?
Personal loans can cover a variety of financial needs and have grown in popularity in recent years, with balances reaching a record high in mid-2018.
These loans are often unsecured, which means they’re not backed by your house or car like a mortgage or auto loan would be. You receive the money upfront and make payments over time, usually with fixed payment terms. The interest rates are often higher than home or car loans, but lower than those for credit cards.
Personal loans can range from about $1,000 to $100,000. Tom Parrish, vice president, head of retail lending product management at BMO Harris Bank, says in his experience, it’s most common to see personal loans totaling $12,000 to $15,000, with a fixed rate for 12 to 60 months.
The most common uses for a personal loan are to consolidate debt, pay for a home improvement project, or cover unexpected expenses or a large purchase, according to a 2018 U.S. News survey.
“People might have three different credit cards and have racked up some debt, so now they want to consolidate it into one fixed-rate payment,” Parrish says.
Since the loan is unsecured, your credit history and ability to pay are vital considerations for lenders. The higher your credit score, the more likely it is you’ll be approved and get a favorable interest rate, Parrish says.
The application process for personal loans should be straightforward, so be wary of scams that offer advanced fee loans, which require an upfront fee. You might never hear from them again after you send your payment and information.
What Is a Home Equity Loan?
For homeowners, the difference between the amount your property is worth and your current mortgage balance, if any, is equity. If you apply for a home equity loan, you’re offering that equity as collateral for the loan.
As with a personal loan, you’ll receive the home equity loan amount in a lump sum and pay it back over time, usually with a fixed interest rate.
Since home equity loans are secured by and based on the value of your home, they’re often called second mortgages. Before approval, lenders will need to follow some of the same processes they would for your first mortgage loan, including ordering an appraisal. It’s worth checking with multiple lenders to find out which one has the most reasonable fees and closing costs.
Home equity loans are secured, which means borrowers should get a lower interest rate than with unsecured loans. Also, the loans can be for a variety of lengths, typically ranging from five to 30 years.
One of the key factors lenders will consider with home equity loans — in addition to your equity, income and credit score — is the loan-to-value ratio, commonly referred to as LTV. The lender will make sure that the combined debt between your original mortgage and the equity loan is less than the estimated sale price of the home.
“The lower the LTV, likely the lower the interest rate,” Parrish says. For example, if you apply for a loan with a loan-to-value ratio of 90 percent, the interest rate would be higher than if your LTV was 85 percent. That’s because the lender faces more risk, Parrish says.
Like with a personal loan, you can use home equity loans for a variety of financial needs. Although limitations may vary by lender, borrowers are generally able to use home equity loans with few, if any, restrictions.
Advantages of Personal Loans
Personal loans are best if you:
— Have a strong credit history and earning potential and would like to quickly obtain the funds you need.
— Don’t own a home or haven’t owned your home long enough to build significant equity.
— Own a home in an area where home prices are flat or declining. If you take out a home equity loan and your home’s value declines, your combined mortgage balances could be larger than the actual home value.
Specific personal loan advantages include:
Faster approval process. The approval process for personal loans is almost always quicker. For a home equity loan, the lender will review your application with many of the same processes it used in the original mortgage review, and it can take a month or more, says Steven Sumner, manager of equity lending at Navy Federal Credit Union.
Parrish says, “You can really get a personal loan sometimes as fast as a few minutes or a few days — versus for home equity, you’re going to go through a complete underwriting and valuation on your house.”
Less hassle for smaller amounts. If you’re borrowing only $10,000, it might seem a bit over the top to go through the full underwriting process for a home equity loan. Instead, a personal loan allows you to get the money with less paperwork and closing requirements, such as appraisal. Additionally, some lenders won’t allow you to obtain home equity loans for small amounts. For example, Discover has a minimum of $35,000.
Your home is not at stake. Defaulting on a personal loan can damage your credit score. But it doesn’t directly affect your ability to stay in your home.
However, if you can’t meet the terms of a home equity loan, the lender could foreclose on your home. This is why it’s usually not a good idea to use home equity loan funds for risky investments, such as starting up a new business.
Advantages of Home Equity Loans
Home equity loans are ideal for homeowners who have significant equity in their homes. Some specific advantages include:
Flexibility. With a home equity loan, terms can be much more flexible than with a personal loan. It’s typical for personal loans to be limited to five or six years, but home equity loans may have terms as long as 30 years.
“As you think about taking out a larger amount of money, you can manage your payments much better in a home equity loan,” Parrish says.
The amount of a home equity loan can be much higher than a personal loan as well. Personal loans don’t typically go higher than $100,000, but some home equity loans go much larger than that, as long as you have enough equity in your home.
Lower interest rates. Your interest rate for a home equity loan will likely be lower than one for a personal loan because the balance is secured by the equity in your home. Lower interest rates can save you thousands — if not tens of thousands — over the life of a loan.
“When you use equity as collateral, it puts the lender in a better situation, and they’re more likely to lend at a lower interest rate,” Sumner says.
Possible tax deduction. If your home equity loan is used to buy, build or substantially improve the home that secures the loan, the interest could be tax deductible, according to the IRS.
Other Borrowing Options
If neither loan option appeals to you, there are other ways to obtain the money you need.
HELOC. A popular option is a home equity line of credit, also known as a HELOC. HELOC funds are secured based on the amount of equity you have in a home, which makes it similar to a home equity loan. But it’s also like a credit card because you have a revolving line of credit. HELOCs are preferred by many homeowners because they allow you to use the money over a period of time instead of getting a lump sum all at once.
For example, if you took out a HELOC for $50,000 to finance a home renovation, you could pay one contractor $10,000 now, then another contractor $10,000 a month later and still have $30,000 ready to pay other contractors when it’s time. “You won’t pay interest on it until you start to use it,” Parrish says.
Also, with HELOCs, you can pay back the money you’ve spent and then re-use it, Parrish says.
Interest rates will vary with HELOCs. They often are indexed against the prime rate, although there usually are options to lock in a rate as well. Be aware of the limitations and requirements of your agreement with the lender. For example, you likely can draw from the HELOC for a designated period of time and then have to pay it back over a specific number of years or possibly with a large balloon payment at the end.
The approval process for HELOCs is similar to that of home equity loans. You’ll encounter closing costs and fees, and the lender will evaluate where you stand on LTV. HELOCs also have tax advantages similar to those of home equity loans.
HELOCs are expected to increase in the coming years. A 2017 study from the credit bureau TransUnion predicted about 10 million homeowners would take out a HELOC between 2018 and 2022, which is more than double the amount from 2012 to 2016.
Credit cards. Credit cards can be a good option for major purchases if you earn rewards and can pay off the debt each month to avoid high interest rates.
Unsecured personal line of credit. A personal line of credit is an unsecured version of a HELOC and allows you to have flexibility in how you much you want to draw and can pay back. It is worth considering as an option instead of a credit card, but because the line of credit is unsecured, its interest rate may be higher than a HELOC secured by your home.