Both personal loan and home equity loan allow you to borrow a lump sum of money that you repay in fixed monthly payments, but each financial product comes with its own benefits and drawbacks. Tapping your home equity may be a smarter move than borrowing an unsecured personal loan in some cases, and vice versa.
If you’re considering taking out a loan to make home improvements, finance a large expense or consolidate high-interest debt, carefully weigh the pros and cons of personal loans and home equity loans in the analysis below.
An unsecured personal loan is a type of loan that allows you to borrow money without using an asset as collateral. You receive the loan proceeds in a lump sum, which you typically repay in fixed installments over two to five years.
Personal loan amounts range from about $1,000 to $50,000, although some lenders may extend larger loans to well-qualified borrowers. Some personal loan lenders may also offer longer loan repayment terms, such as 10 or more years.
Personal loan rates are usually fixed, but variable-rate personal loans may also be an option. Interest rates can vary widely, from as low as 6% to as high as 36%. Plus, you may have to pay a loan origination fee of up to 5% of the loan amount, which can be deducted from the loan proceeds you receive. Some lenders also charge a prepayment penalty for paying off the loan early.
Since personal loans are usually unsecured, the lender bases your interest rate and eligibility on your credit score and debt-to-income ratio. Applicants with very good credit, defined as a FICO score of 740 or higher, will see more favorable repayment terms and lower interest rates than those with bad credit.
Borrowers with fair or poor credit may not qualify for a personal loan, or they may have to enlist the help of a creditworthy co-signer. Alternatively, those with bad credit could consider borrowing a secured personal loan that’s backed by collateral, such as a car title or savings account.
The personal loan application and approval process is relatively straightforward. Most lenders let you get prequalified with a soft credit inquiry, allowing you to see your estimated interest rate, loan amount, and monthly payments. When you apply for the loan, the lender will conduct a hard credit check, which will have a temporary and minimal negative impact on your credit score. Upon loan approval, the lender may disburse the funds directly into your bank account as soon as the next business day.
Here are the advantages and disadvantages of personal loans:
|Funds may be disbursed as soon as the next business day after approval.||Interest rates may be high, especially for those with fair or bad credit.|
|You don’t have to use your home as collateral, so you don’t risk losing the roof over your head.||Personal loans may come with loan origination fees, late payment fees and prepayment penalties.|
|You can typically get prequalified to view your estimated rates and terms with a soft credit check.||Personal loans may have shorter repayment terms and smaller loan amounts than home equity loans.|
|Your interest rate and monthly payments will be fixed during the repayment term.||The overall cost of borrowing a personal loan may be higher than tapping into home equity.|
|You may be able to enlist a co-signer or borrow a secured personal loan to qualify for a lower rate.||Not all personal loan lenders allow co-signers or offer secured loan options.|
A home equity loan, also known as a second mortgage, is a secured lump-sum loan that uses your home as collateral. Like with a personal loan, you repay the debt at a fixed interest rate, which means your monthly payments will stay the same until the loan is repaid in full.
You’ll typically need at least 20% equity in your home to qualify, since most lenders require you to carry a loan-to-value ratio, or LTV, of 85% or higher. Your home’s equity is the value of your home minus what you owe on your mortgage. For example, if your home is worth $350,000 and your mortgage balance is $225,000, you have $125,000 in equity – or about 36%.
Most home equity loans come with repayment terms of between five and 20 years, but some lenders may offer longer terms of up to 30 years. During this time, you’ll likely have two monthly payments on your home: your primary mortgage payment and your home equity loan payment.
Compared with personal loans, home equity loans typically come with much lower interest rates, making them less expensive to repay over short periods of time. Current home equity loan rates are around 8% to 11%, depending on the applicant’s LTV ratio, credit score and other factors.
However, the cost of borrowing a home equity loan can vary based on the lender’s fees. You’ll usually have to pay closing costs, which range from about 2% to 5% of the loan amount. And because the loan has to go through the closing process, it can take much longer to receive the funds, up to six weeks or more in some cases. Like with personal loans, the lender will conduct a hard credit check when you apply.
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Here are the benefits and drawbacks of home equity loans:
|Interest rates are typically lower for secured loans, such as home equity loans.||Loan funding may take longer than a month since you’ll have to go through the closing process.|
|Home equity loans can come with longer loan repayment terms of up to 30 years.||Your home is used as collateral, which means you may lose your home if you default on the loan.|
|The interest payments may be tax-deductible if you use the loan proceeds to make home improvements.||You’ll pay closing costs that range from around 2% to 5% of the loan amount.|
|Your interest rate and monthly payments will be fixed during the repayment term.||Lenders typically require you to maintain an LTV ratio of 85% or higher, meaning you need to have at least 15% equity after borrowing the loan.|
Personal loan funds can be used for virtually anything, from consolidating debt to financing a large purchase. And in many circumstances, a personal loan can be the right borrowing tool to help you meet your financial goals. Here are some cases in which you may choose a personal loan over a home equity loan:
- You need money for an immediate expense. Since home equity loan approval and disbursement can take a month or longer, personal loans can be a better option if you need money fast.
- You only need to borrow a small amount of money. The minimum borrowing amount on a home equity loan may be larger than what you need to borrow, while personal loan amounts may be as low as $1,000.
- You can qualify for the lowest interest rates available. Applicants with very good or excellent credit may qualify for personal loan rates that are competitive with home equity loan rates.
- You don’t want to use your home as collateral on the loan. If you default on a home equity loan, you could lose your home. But with an unsecured personal loan, you don’t risk your assets.
- You don’t have enough equity in your home. Most home equity loan lenders require you to carry a minimum LTV ratio of 85%, which could be prohibitive for those who recently bought a home.
Although borrowing a home equity loan can sometimes be a more complex process than taking out a personal loan, it can pay off in the form of lower interest rates. Plus, choosing a home equity loan can come with additional financial benefits like tax breaks and more flexible repayment options. Here are some cases in which it may be wise to borrow a home equity loan instead of a personal loan:
- Your goal is to pay less money in the long run. Although loan funding may take longer with a home equity loan, the process may be worthwhile if the interest rate is much lower than with a personal loan.
- You plan on using the loan proceeds to make renovations. The interest you pay on a home equity loan may be deducted from your federal income tax if you use the funds to make improvements to your home.
- You have a good amount of taxable equity in your home. If the value of your home has risen since you bought it, you may be able to tap into those price gains in the form of a low-interest home equity loan.
- You want a longer repayment term. Home equity loans can be repaid over a period of up to 10, 15 or 30 years, whereas personal loans are typically repaid in five years or less.
- You’re confident in your ability to repay the loan. Since the lender may seize your home as collateral if you go into default, you should only borrow a home equity loan if you’re comfortable with the repayment terms.
Alternatives to Personal Loans and Home Equity Loans
Home equity loans and personal loans both offer a way for consumers to borrow a lump sum of cash, but they’re not the only financing tools at your disposal. If these borrowing options don’t sound right for you, consider some of your alternatives in the sections below.
Home Equity Line of Credit
Like a home equity loan, a home equity line of credit, or HELOC, is a way to tap into your property’s unused value, with tax benefits for those who use the funds to make home improvements. But whereas home equity loan proceeds are issued in a single lump sum, a HELOC allows you to borrow – and pay interest on – only the amount of money you need.
Rather than a loan, a HELOC is a revolving line of credit that’s similar to a credit card. You can borrow against your home equity, only using as much or as little as needed during a set period of time. This way, you can strategically tap into the funds multiple times without overborrowing or having to reapply for a loan.
But also like a credit card, HELOCs typically have variable interest rates, which means the price you pay to borrow money can change with market conditions. This can make the overall financing costs less predictable, especially since HELOC repayment periods can last between 15 and 25 years.
Cash-Out Mortgage Refinancing
A cash-out mortgage refinance is when you replace your existing home loan with a new, larger mortgage that has different repayment terms and monthly payments. The excess proceeds from your refinanced mortgage are typically issued to you at closing, which you can then use as you see fit.
While a home equity loan is a second payment on top of your current mortgage, cash-out refinancing allows you to keep a single monthly payment. When you refinance your home, you can change your repayment term, such as switching from a 30-year mortgage to a 15-year term. You’ll also get a new interest rate – your rate and repayment length will determine your monthly payment.
Cash-out refinancing can be a good strategy for tapping into your home’s equity if you also want to change your repayment terms. But if you’re sitting on a record-low interest rate from 2021, then cash-out refinancing means you’ll sacrifice it. Since mortgage rates are currently much higher, refinancing in today’s environment can result in less favorable repayment terms.
Depending on your reasons for borrowing money, using credit cards may offer a smarter alternative to borrowing a loan. For example, if you simply need to cover a large purchase, such as an appliance, you may be able to take advantage of deferred-interest financing by using a store credit card. Or if you need to cover an unexpected expense, opening a credit card with a 0% annual percentage rate introductory period may be an option.
As with any financial tool, the benefits of using a credit card will depend largely on your financial situation. You’ll need very good or excellent credit to qualify for zero-interest credit cards. Plus, 0% APR periods are a short-term solution, as they typically last for up to 18 months – at which point the rate resets to the purchase APR. This is particularly important if you use a deferred-interest store card.
If you’re planning to use a credit card as a financing tool, be sure you have a repayment plan in place before you make a purchase. Read the terms of the card agreement carefully to familiarize yourself with any annual fees, late payment fees or penalty APRs you may run into. This way, you can avoid becoming trapped in a cycle of high-interest debt that’s difficult to repay.