Personal loans are unsecured and have a relatively simple application process, but you’ll need good or excellent credit to qualify for the best terms. Home equity loans could be easier to qualify for if you have a lower credit score and the rates are lower, but the application process is lengthier and the loan uses your home as collateral.
Consequently, deciding which one is best for your financial situation can be challenging as they both come with significant benefits and drawbacks.
How do personal loans work?
Personal loans are offered by online lenders, banks and credit unions. These loans can be used for a variety of needs, from funding a large expense to consolidating debt. Borrowers with good to excellent credit scores are the most likely to get approved and find a low interest rate. But that doesn’t mean that applicants with fair to low credit scores can’t get personal loans.
Applying for a personal loan can be as simple as filling out an online form and providing electronic documentation, but because each lender structures its loans differently, it’s always a good idea to shop around before making a choice. Compare quotes from multiple lenders and see which offers a loan amount that fits your needs and a repayment term and interest rate that fit your budget.
Once you’re approved for a loan, you can typically receive funds in a matter of days, and you’ll make fixed monthly payments on the loan until it’s paid off.
How do home equity loans work?
Home equity loans enable homeowners to use the equity they’ve built up in their homes to take out loans. They typically let borrowers make payments over five to 15 years, although terms vary. Most lenders will let you borrow up to 85 percent of your home’s combined loan-to-value ratio.
In addition, a home equity loan has one big advantage over a personal loan: lower interest rates. This is because the loan uses your home as collateral, so the lender may have a claim over your home if you default on your loan.
Unlike with a personal loan, the application process for a home equity loan is a bit more involved. While you can often apply online, the process usually takes a few weeks, since an evaluation of your property must take place.
When you receive a home equity loan, you will get the entire amount at once and must repay it in fixed monthly installments.
When to choose a personal loan
A personal loan may be a better choice than a home equity loan in some scenarios:
- You have a smaller expense: While you may be able to find smaller home equity loan amounts at local credit unions, most banks set a minimum of $10,000 or more. Personal loans, on the other hand, may let you take out as little as $1,000.
- You don’t want to risk your house: Personal loans are usually unsecured, so you can’t lose your house or any other property if you default.
- You don’t have much equity: If you lack sufficient equity in your home, you may not qualify for a home equity loan at all.
- You have excellent credit: Having excellent credit will qualify you for the lowest personal loan rates, some of which may hover around 3 percent.
Howard Dvorkin, CPA and chairman at Debt.com, says that if you’re looking to pay off credit card debt, a personal loan is a better option. “If someone has multiple credit cards — totaling more than $5,000 — and a credit score that will qualify them for a reasonable interest rate, a personal loan to consolidate debt may be the right option for them,” he says.
When not to choose a personal loan
It’s in your best interest not to choose a personal loan if you need to borrow a sizable amount of money that exceeds the lender’s loan limit. You should also steer clear of personal loans if you have bad credit and can only qualify for steep interest rates that result in excessive borrowing costs and make the monthly payment unaffordable.
When to choose a home equity loan
In some cases, a home equity loan may be the best option available. You may want to consider a home equity loan if:
- You have a lot of equity: If you’ve built up a significant amount of equity in your home, you may be able to borrow upward of $500,000, far more than you would with a personal loan.
- You don’t have the best credit score: Because a home equity loan is a secured loan, it can be easier for people with subpar credit to qualify — just know that you won’t receive the best interest rates.
- You’re looking for low rates: Home equity loan rates are typically lower than personal loan rates, meaning your monthly payment will be smaller and you’ll pay less for borrowing money.
- You want to renovate your home: If you use your home equity loan funds for renovations, you can deduct the interest paid on your taxes.
When not to choose a home equity loan
Even if you could qualify for a low interest rate on a home equity loan, you should avoid it if you have very little equity in your home. If not, the closing costs and amount you pay in interest could easily outweigh the benefit of taking out a home equity loan in the first place. Another reason to skip a home equity loan is if money’s tight and you’re living check-to-check. Otherwise, you risk losing your home to foreclosure if you fall behind on the loan payments.
Alternative borrowing options
Personal loans and home equity loans aren’t the only ways to borrow a large sum of money. If you have different financial needs in mind, try one of these alternatives.
Home equity line of credit (HELOC)
A HELOC works like a credit card. You get a line of credit secured by your home and can use those funds for almost any purpose. HELOCs often have lower interest rates than other types of loans, and the interest may be tax deductible.
As with a home equity loan, you are borrowing against the available equity in your home, which is used as collateral. You can borrow as much as you need as often as you like throughout the draw period — usually 10 years. You can replenish your available funds by making payments during the draw period. 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. As with a home equity loan, you can often borrow up to 85 percent of the value of your home, minus the outstanding balance on your mortgage. When you apply, lenders will look at your credit score, monthly income, debt-to-income ratio and credit history.
Most HELOCs have variable 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, you may find yourself saddled with large payments during the repayment period.
Today’s best credit cards offer a lot of advantages. Making payments on time every month can improve or build your credit rating, and many credit cards offer cash back rewards or frequent flyer miles that you can redeem on certain airlines. They are as convenient as cash and can be used as a financial safety net for emergencies.
Credit cards do have some downsides, though. 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. Additionally, some cards have high annual fees (from as little as $25 to more than $1,200), you may experience surcharges from merchants when you pay with your credit card and add-on fees can accumulate quickly.
Home improvement loans
Due to the unsecured nature of home improvement loans, they typically carry higher interest rates, but they are ideal for borrowers who are planning small or midsize renovations and don’t want to use their property or homes for collateral.
When it comes to home renovations, however, Dvorkin advises sticking to a home equity loan. “This adds value to a home, instead of putting it at risk, and helps consumers build equity in the long run,” he says. Plus, the interest used on home improvement projects may be tax-deductible if you use the loan to buy, build or improve your home.
The bottom line
The choice between a personal loan and a home equity loan depends on your financial needs. Both loan types have advantages and downsides to be considered before applying, but both are suitable options if you need to borrow money. Either way, take the time to compare all your loan options, interest rates, fees and repayment timelines before submitting your application.
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