Home Equity Loan vs. Personal Loan: Which is Better for You?
If you need money to pay off maxed-out credit cards, make some long overdue home improvements or you just need a cash cushion, you might be weighing the pros and cons of a home equity loan versus a personal loan. Both loan options allow you to borrow money in a lump sum and make fixed payments for the term you choose.
Understanding the differences in the risks, rates and approval processes for a home equity loan versus a personal loan can help you choose the best option for your financial needs.
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How home equity loans work
Sometimes called a second mortgage, a home equity loan is borrowed against the equity in your home. Home equity is the difference between your home’s value and the balance you owe on your current mortgage.
For example, if your home is worth $400,000 and your first mortgage balance is $300,000, you have $100,000 worth of home equity. That doesn’t mean you can borrow the entire $100,000 – home equity lenders set limits on how much you can borrow based on loan-to-value (LTV) ratio rules.
Home equity loans work a lot like regular fixed-rate mortgages:
- Lenders qualify you based on your income, debt and credit scores
- The maximum loan amount is based on the value estimate from a home appraisal
- Funds are sent to you in a lump sum
- Monthly payments are based on a fixed interest rate
- Home equity loan closing costs typically range between 2% and 5% of the loan amount
- The mortgage interest may be tax deductible
- A lien is recorded against your home until the loan is paid off
- If you can’t make payments and default, you could lose your home in a foreclosure
How personal loans work
A personal loan is a form of credit that comes in a lump sum with fixed interest rates and is repaid in monthly installments.
Personal loans can be secured — meaning you’ll have to provide collateral like a vehicle or savings account — or unsecured, which doesn’t require collateral. Unsecured loans are the most common, so lenders pay particular attention to your credit score and credit report.
Personal loans typically range from $1,000 to $100,000. Rates are dependent on the borrower’s credit and the term and amount of the loan; APRs commonly fall between 6.99% and 36.00%. Uses for personal loans are usually flexible, but some lenders specify how you can or can’t use loan funds. For instance, most lenders won’t allow you to use the money toward business expenses or post-secondary education.
Personal loans work similarly to home equity loans, though there are some important differences:
- Loan approval is based on your credit score and credit history
- You receive funds in the form of a lump sum
- Collateral is not required unless it’s a secured personal loan
- Repayment terms typically range from two to seven years
- Can take anywhere from one business day to a week to receive loan funds
- Loans do not come with tax benefits, as they are not tax deductible
- Interest rates may be higher than home equity loans depending on the market and your credit score
Home equity loan vs. personal loan: Which is best for you?
Before you decide which type of loan is right for you, check out the approval requirements and common loan features. Home equity loans usually require a more in-depth look at your finances, while personal loans focus on just your credit and income.
| Loan feature | Home equity loan | Personal loan |
|---|---|---|
| How money is received | Lump sum | Lump sum |
| Interest rate | Fixed average rate (APR) typical range between 5.86% and 7.83%* | Annual percentage rate (APR) typically range between 6.99% and 36.00% |
| Term | Five to 30 years | Two to seven years |
| Minimum credit score | Varies; often 620 | Varies; often 600 |
| Loan amount limits | Vary based on home equity lender but typically higher than personal loans | Can range from $1,000 to $100,000 |
| Maximum LTV ratio | 85% of your home’s value | N/A |
| Secured by your home | Yes | No |
| Paperwork required | Income Assets Credit Title Appraisal | Income Credit Personal information Assets (only with secured loans) |
| How long to receive funds | Two to four weeks | One to seven days |
| Closing costs | 2% to 5% of your loan amount | May have to pay origination fee, typically up to 8% |
*Based on closed loans on the LendingTree platform for first half of 2022
When to choose a home equity loan
Consumers borrow money for a wide variety of reasons, and for homeowners, home equity loans can be an inexpensive way to borrow. A home equity loan is a good choice if:
You’ve built up a big chunk of equity in your home. Home equity lenders don’t typically allow you to borrow all of your home’s equity, so you’ll need enough to make the loan worth it.
You want the lowest payment possible. Home equity loan rates are typically lower than personal loan rates because they’re secured by your home. In addition, these loans are available with terms as long as 30 years, which gives you a much lower rate than a loan you have to pay off in two to seven years.
You can afford two mortgage payments. A home equity loan is usually called a “second mortgage” because you’re adding it on top of your current “first” mortgage. Make sure there’s plenty of room in your budget for two house payments.
When to avoid a home equity loan
What goes up, must come down, and that’s true even when it comes to home equity. They call it the housing “market” for a reason — like other financial markets, housing prices can fall. You may want to avoid a home equity loan if:
Home prices are dropping in your area. If home values are falling in your neighborhood, you should hold off on a home equity loan. You don’t want to end up with an underwater mortgage on your home, which means that your total mortgage balances are more than your home is worth.
You’ll be moving or relocating for a job in the near future. If your employer is talking about a promotion – and possibly a move – to another state, push pause on your home equity loan plans. You’ll want to make as much money as possible when you sell your home, and a home equity loan would cut into your profit at closing.
You want to leave your home equity alone. A home equity loan converts money you could make when you sell into debt. It could also put you at risk of losing your home, which is not something you have to worry about with a personal loan. If you aren’t comfortable using your home as collateral or don’t want to touch the equity, this might not be the best option for your needs.
When to choose a personal loan
Whether you’re planning a home improvement project or paying for medical expenses, a personal loan can offer flexibility and plenty of perks. A personal loan is a good choice if:
You want to consolidate debt into a single loan. If you’re struggling to keep track of all your debts, from credit cards to other personal loans, a personal loan for debt consolidation may be a good option for you. As long as you have good credit, you may be able to score a lower interest rate and compound all of your payments into a single monthly due date.
You don’t own a home. Home equity loans are only accessible to homeowners. Unsecured personal loans, on the other hand, aren’t backed by assets like your home. This can make them more accessible to non-homeowners.
You have good credit. Personal loan APRs can be as low as 6.99%, sometimes lower depending on the market. Those low rates are only offered to borrowers with good credit. With a good credit score, you may qualify for lenders’ lowest APRs, lowering your total cost to borrow and saving you money. If you have bad credit, however, taking out a loan is likely to be more expensive.
You know how much money you plan to spend. Because personal loans come in a lump sum, it’s important to know how much money you plan to spend ahead of time. Unlike a personal line of credit, it’s difficult to go back to your lender and ask for more money if you’ve already taken out a loan.
When to avoid a personal loan
Personal loans aren’t always a silver bullet to your financial needs. You may want to avoid a personal loan if:
You have a low credit score. Personal loan APRs can be as high as 36% or higher. While that’s nowhere near the 400% APR of payday loans, that could still cost you a lot of money in interest charges. When comparing loan offers, use a personal loan calculator to gauge how much the loan may cost you in interest.
You don’t know how much money you need. If you’re unsure about how much money you’ll need to reach your goals, consider forms of credit that operate with revolving credit, such as credit cards and personal lines of credit.
You can’t afford the monthly payments. If you default on a loan, even if it’s unsecured, you could still face legal consequences and a severe hit to your credit score.
You have an emergency expense. Because it takes time to make it through the personal loans application and funding processes, this form of credit may not be for you if you’re in a hurry. That being said, there are emergency loan options out there for those who need quick access to cash to cover unexpected costs.
Pros and cons of home equity loans and personal loans
As with any financial decision, there are risks and benefits to both of these loan products. Here, we explore the pros and cons of both home equity loans and personal loans.
| Pros | Cons | |
|---|---|---|
| Home equity loans | Lower interest rates Longer terms are available May be tax-deductible You may be eligible for higher loan amounts | More paperwork required for approval Longer wait time before you receive your funds Higher total closing costs You put your home at risk of foreclosure if you default |
| Personal loans | No risk to losing valuable assets such as your home Application process is shorter and more straightforward Typically low or even zero fees Same-day or next-day funding available with some lenders | Higher interest rates than home equity loans No tax benefits Smaller loan amounts Much shorter loan repayment terms |
Alternatives to home equity loans and personal loans
Before you commit to a home equity or personal loan, consider these additional options:
Cash-out refinance
If current interest rates are low, you can replace your current home loan with a larger mortgage and pocket the difference in cash. Most cash-out refinance programs cap your LTV ratio at 80%, but you may qualify even if you have a credit score below the standard minimum of 620.
Home equity line of credit (HELOC)
A HELOC works like a credit card that’s secured by your house. You can use the funds as needed and pay the balance off during a set time called a “draw period.” The interest is generally variable and sometimes includes an option to make interest-only periods for a limited time.
Credit cards
Credit cards can be a quick way to access funding. Some cards may even help you save money if you qualify for a 0% intro APR credit card. However, credit cards work more like a line of credit, so you won’t receive a lump sum. You’ll only have to pay interest on whatever you spend.
Tap your emergency fund
Since none of us have a magic crystal ball that can tell the future, it’s better to be safe than sorry and start building an emergency fund. To begin stockpiling savings for a rainy day, you can:
- Decide on a goal. Whether you want to set aside $1,000 or $5,000, start by choosing a savings goal. Setting a deadline for yourself can be a good way to hold yourself accountable and ultimately reach your emergency fund goal.
- Automatically transfer funds to a savings account. It can be easy to forget or tempting to skip funneling money into your savings account. Setting up a monthly automatic transfer, however, can make the process much more convenient.
- Live by a reasonable budget. When you budget for your emergency fund, you’ll want to set reasonable expectations so you still have enough money to cover your bills. Budgeting also includes keeping track of your spending habits and potentially cutting unnecessary spending so you can more easily save up.