Both personal loans and home equity loans can be used for making home improvements, consolidating debts, financing your education, medical expenses, and almost anything else. But there are advantages and disadvantages to both types of loans, so the more you understand about each type, the better decisions you can make. Let’s take a look at the major differences so you can make the best possible choice.
How do personal loans works?
Personal loans are offered by a wide range of online lenders, banks, and credit unions, and can be used for a variety of needs, from funding a large expense to consolidating debt. Borrowers with a good to excellent credit score have the best options when shopping for a personal loan, which means they are more likely to get approved and find a low interest rate. But that doesn’t mean applicants with fair-to-low credit scores can’t get a personal loan.
Applying for a personal loan is pretty straightforward (you provide documentation and fill out an application), but because each lender structures its loans differently, it’s always a good idea to shop around before making a choice. The first step is to decide how much money you need, and only borrow what you can comfortably pay back in monthly installments.
Next, figure out which type of loan is best for your needs:
- An unsecured personal loan that doesn’t require collateral
- A secured personal loan, which is backed by collateral (and thus might offer a lower interest rate)
- A debt consolidation loan
- A medical loan to finance medical or dental procedures
Then, compare quotes from multiple lenders. When shopping for a lender, take a look at what you value most, and check out each lender’s rates since they can vary widely. After that, check your credit score if you haven’t done so already. Your score typically determines how much you qualify for and can even eliminate lenders if your score is too low.
Finally, find out what your lender’s requirements are for applying for your personal loan. Most lenders look at your credit rating and credit history, annual income, and debt-to-income ratio. If you know where your finances stand, the application process will go more smoothly.
How do home equity loans work?
A home equity loan is also referred to as a second mortgage. Your home’s equity is the amount of money you’ve paid on your mortgage since purchasing the home, as opposed to its total value.
Home equity loans enable a homeowner to use the home equity they’ve built up in their home to take out a loan. A home equity loan typically lets borrowers make payments over a long period of time, which can be as short as five years or as long as 10 or even 15 years, although terms vary. It’s also not unusual for someone to borrow up to 85 percent of the equity in their home.
In addition, a home equity loan has one big advantage over a personal loan — lower interest rates, because this type of loan is a secured loan with your home as collateral.
Unlike a personal loan, the application process for a home equity loan is a bit more involved. In some cases, the process can happen quickly (especially if you apply online), and you can be approved in days, or it could take anywhere from two to six weeks. It all depends on your home’s value and how much equity you’ve built up, as well as your financial situation and credit history.
The verification process is usually what takes the most time or causes the most delays to your home equity loan approval. That’s because you must gather all the required documents, and an evaluation of your property must take place.
When you receive a home equity loan, you will get the entire amount at once (as opposed to a home equity line of credit, or HELOC, which works much like a credit card).
Personal loans vs. home equity loans: which is best for you?
A home equity loan can be a good option when you need a large amount of money. Interest rates are lower, so monthly payments are typically smaller, which can be spread out over a long period of time. If you have good credit and a steady income, you can often borrow up to 85 percent of the equity you’ve built up in your home.
However, a home equity loan is secured with your home as collateral. That means if you default on your loan or can’t make payments, you might be in danger of foreclosure.
A personal loan is a better choice is you’re funding a smaller expense, and you don’t want a loan hanging over your head for a long period of time. Personal loans are usually unsecured, so unlike a home equity loan, you can’t lose your house or any other property if you default. Once your loan agreement is signed, your interest rate is fixed for the entire term of your loan. Personal loans are a great option if you lack sufficient home equity to borrow against your home, they can be used for most any purchase or to consolidate debt, and they come in a wide range of dollar amounts.
Alternative borrowing options
Home equity lines of credit (HELOC)
HELOCs work much the same as a credit card where you can get a line of credit secured by your home, used to fund large expenses or to consolidate higher interest rate loans or other debt, such as credit cards. HELOCs often have a lower interest rate than other types of loans, and the interest may be tax-deductible.
Like a home equity loan, you are borrowing against the available equity in your home, which is used as collateral. As you pay down your loan, the amount of available credit is reloaded, like a credit card. That means you can borrow as much as you need as often as you like throughout the draw period — usually 10 years. At the end of the draw period, you will begin the repayment period, which is typically 20 years.
To qualify for a HELOC, you need equity in your home. Like a home equity loan, you can often borrow up to 85% of the value of your home, minus the outstanding balance on your mortgage. When applying, lenders will look at your credit score, monthly income, debt-to-income ratio, and credit history.
Most HELOCs have interest rates, meaning your rate can fluctuate over the term of your loan. As interest rates go up, so does your payment. Also, as with credit cards, the chance for overspending is greater than with a fixed-sum loan. Without a certain amount of discipline and budgeting, it can be easy to find yourself saddled with large payments during the repayment period.
Credit cards offer a lot of advantages. Making payments on time every month can improve or build your credit rating. Many credit cards offer reward points for every dollar you spend or frequent flyer miles you can redeem on certain airlines. They are safe to use and as convenient as cash and can be used as a financial safety net for unexpected emergencies. And just like a loan, they can be used to consolidate debt and save money on high-interest loans.
Credit cards do have some downsides. Some credit cards charge high interest rates on cash advances and balance transfers. Missed or late payments can damage your credit, and there is always the chance of credit card fraud on your account. Some cards have high annual fees (from as little as $25 to more than $1,200 per month), you may experience surcharges from merchants when you pay with your credit card, and add-on fees can add up quickly.
The bottom line
The choice between a personal loan or a home equity loan depends on your financial needs. Both loan types have pros and cons to be considered before applying, but both are suitable options when making home improvements, consolidating debt, financing your education, paying for medical expenses, or almost anything else. Either way, take the time to compare all your loan options, interest rates, fees, and repayment timelines.