A homeowner’s first instinct is to get a home equity loan or line of credit when they need money for a home improvement project. But in many cases, a personal loan, despite its higher interest rate, is a better choice.
With a personal loan, you know your total borrowing costs at the time you take out the loan, and you’re borrowing a fixed amount for a certain number of years with a fixed interest rate.
With a HELOC, you’re borrowing different sums at different times. The interest rate changes with market conditions. The initial payments can be interest only or interest plus some principal, while later payments are fully amortized interest and principal. With so many variables, there’s no way to know your total borrowing costs upfront.
A home equity loan solves the uncertainty problem, but still has disadvantages compared with a personal loan.
Here are 5 reasons to consider a personal loan for your next home improvement project.
1. Your home is less at risk
If you can’t repay your home equity loan or HELOC, your lender can eventually foreclose because these loans are secured by your home. The stakes are lower with an unsecured personal loan.
While unsecured creditors can place a lien against your home if you don’t pay them –something many consumers are unaware of — the lien usually just makes selling or refinancing more difficult. It won’t get you kicked to the curb like a foreclosure will unless the creditor gets a writ of execution from a judge to force the sale of your property, which isn’t likely.
“The thing to keep in mind is that real estate loans typically are non-recourse loans,” says Joe Parsons, senior loan officer with PFS Funding in Dublin, California, and author of The Mortgage Insider blog. “This means that, in most cases, the lender can look only to the property as security for the debt. With a personal loan, the lender can pursue the borrower’s other assets and income sources in the event of default.”
In other words, defaulting on any loan is never a good option. However, an unsecured personal loan may be a lower risk option if you’re financially stable but facing uncertainty, like potential layoffs at work or a child’s tuition that might not be covered by scholarships.
If you definitely see financial trouble ahead, put your home improvement plans on hold until the storm passes. Don’t add to your stress with more monthly payments.
2. You’ll pay less in interest
An unsecured personal loan’s repayment period is usually 3 to 7 years. A HELOC usually has a 10-year draw period plus a 20-year repayment period, and home equity loans give you 20 to 30 years to repay. You’ll pay significantly more interest with a HELOC or home equity loan despite their lower rates.
Let’s say you want to borrow $30,000. With the personal loan, you get an interest rate of 10.5% and you choose to repay it over 5 years. Your total interest expense would be $8,689.
Borrow the same amount with a home equity loan and your interest rate might be 5.25%. Over 20 years, you’ll pay $18,517 in interest. A HELOC might start out at 4.75%, but will probably cost more than the home equity loan over time, since interest rates are near record lows and will likely rise.
Shop for the best rates on personal loans at Bankrate.com.
3. Keep borrowing in check
A personal loan doesn’t tempt you to borrow more than you need.
Unlike a HELOC, which allows you to keep borrowing throughout the 10-year draw period, a personal loan amount is fixed when your loan is approved.
A home equity loan also locks in your loan amount, but both home equity loans and HELOCs often require you to borrow at least $10,000 at closing. There can also be minimums for additional draws on a HELOC.
With a personal loan, the minimum you’re required to borrow is smaller. That makes them a good option for lower-cost home upgrades, like new floors or heating and air conditioning equipment. Minimums vary by lender, but PNC Bank and Lending Club, for example, offer unsecured personal loans of as little as $1,000. Online lender Vouch lets you borrow as little as $500.
Larger or longer-term personal loans sometimes have minimum borrowing requirements similar to those of home equity loans and HELOCs, though, so shop around and read the fine print.
4. Home equity is irrelevant
Underwater on your mortgage? Just bought your house? You won’t be able to get a home equity loan or HELOC because you won’t have enough equity.
These loans typically require you to have 10% to 20% equity left after borrowing. If your home is worth $300,000 and you owe $270,000, you have only 10% equity and you won’t qualify.
But as long as you haven’t maxed out your debt-to-income ratio and your credit is good, you can still get an unsecured personal loan. Not only that, you might get a rate comparable to home equity loan or HELOC rates.
For example, LightStream, a division of SunTrust Bank, offers an unsecured personal loan for home improvement with rates as low as 4.99% for 24 to 36 months on amounts of $10,000 to $100,000.
5. You’ll pay less in fees
Personal loans usually have origination fees, but they don’t have application fees, appraisal fees, annual fees, points, title search and title insurance fees, mortgage preparation and filing fees, or early repayment fees like home equity loans and HELOCs typically do.
Many home equity lenders waive some or all of these fees. But if you pay off your loan within the first 2 or 3 years, the lender will impose an early repayment fee. Sometimes it’s just a few hundred dollars, but other times it includes all the charges that were originally waived, and these can total thousands of dollars.
Under normal circumstances, you probably won’t pay off your loan early, but if moving or refinancing is a possibility, a personal loan could save you a lot in fees.
To find out, figure and compare your potential out-of-pocket expenses, including closing fees and interest, for both the home equity loan and the personal loan, says Jamie Hoggatt, branch manager of SecurityNational Mortgage Company in San Antonio.
“Is it worth the closing costs in order to get a lower interest rate? Will you get the return on your investment?” Hoggatt asks. The answer is in the numbers.