Personal Loan vs. Home Equity Loan: Which Is the Right Choice?
Sometimes when you need funds for school expenses, big-ticket purchases, vehicle down payments, home improvements and other large projects, credit cards and savings just won’t cut it. In those situations, your next choice could be to look into a personal loan or a home equity loan.
The differences between these two types of loans are pretty steep, and that makes it important to take your time deciding which is going to offer the most advantages, lowest cost and best fit.
To help you get there, let’s take a look at some of the questions you need to ask yourself before getting either type of loan.
What is a personal loan?
A personal loan is often an unsecured loan, which means there’s no underlying collateral guaranteeing the loan. Thus, there’s nothing for the lender to repossess should you stop making payments.
While each lender is different, you can often find personal loans in amounts ranging from $1,000 to $50,000, with terms as short as 12 months up to 180 months. Some personal loans are issued without any origination fees, while others may have different fees. They can be issued to people with a range of credit scores, and interest can span from 3.99% to almost 36%.
What is a home equity loan?
Home equity loans are a tool for accessing the difference in value between what you owe on your home and what the property is worth. These loans are secured by the house, which means that if you can’t make monthly mortgage payments, your home could end up in foreclosure.
The maximum you can borrow through a home equity loan is generally 85% of your equity. Interest rates generally start as low as 4.25% to 6%. Loan terms can range from 10 to 30 years.
Which choice is better?
The differences between personal loans and home equity loans are such that there is no simple answer to the question of which is better. It will depend on your personal situation and needs. Here are five questions you can answer to help decide which type of loan best suits your situation.
How quickly do you need the money?
If you need money fast, a personal loan could be a far better choice than an equity loan. Personal loans can get approved and funded within a matter of days. Equity loans require more time for approval. After verifying income, title and other information, your home generally needs to be appraised, and you may have to meet with a notary to sign documents — all before the funds are paid.
How much money do you need?
Personal loans have lower limits for lending than home equity loans, with most of them tapping out around $50,000. Home equity loans can reach into the hundreds of thousands, with limits at about 85% of your total equity. If you have plenty of equity in your home, you can potentially secure a higher amount through an equity loan. If you don’t have much equity, a personal loan may offer you access to more funds.
What kind of payment can you afford?
In general, personal loans need to be paid back sooner than home equity loans, which means your monthly payments are likely to be much higher than they would with a home equity loan. As an example, a $20,000 personal loan with a payment term of five years and an APR of 6% has a monthly payment of $386.66. A home equity loan for the same amount and APR but a 20-year term has a monthly payment of $143.29. So if your income fluctuates, a home equity loan with a lower required payment might be a better option for your long-term budgeting.
What do you need the money for?
Personal loans sometimes have restrictions around the purposes for how they can be used. In some cases, they can’t be used for purchasing cars and real estate or paying for postsecondary school expenses. But equity loans have fewer restrictions.
Besides the restrictions, it’s important to consider the value of the loan against how you’re using it. Home equity loans require you to put your home on the line, meaning that if you lose a source of income and stop making payments, you could lose your house. That’s a considerable risk to take, so you’ll want to evaluate whether that risk is worth it.
How much will the loan cost?
Understanding whether you can afford the monthly payment is one thing. Determining how much you can afford to spend on the loan is different. Loan costs are determined by the fees and interest charged. For example, if you take a personal loan for $20,000 at 6% APR on a three-year term, the interest costs will be $1,903.79. But if you take a $20,000 equity loan for 15 years at 4.25%, the interest costs will be $7,082.02.
In considering this expense, you also want to think about the purpose of the loan. A loan for home improvements that add value to your house upon sale might be worth the money. But adding thousands of extra dollars in interest charges to funds borrowed to make a vehicle down payment might not make as much sense.
Personal loans vs. home equity loans
These days, it seems there’s an almost endless number of types of loans you can get to consolidate debt or help pay for large expenses.
The good news is that some of these loans can offer you a strategic advantage when planning your budget. Some of them are affordable and have terms that result in monthly payments you can easily budget. The trick is to evaluate each of these options on multiple levels to ensure you’re getting the best possible deal at the most affordable rates.