Home Equity Loan Vs. Personal Loan: A Complete Homeowner’s Guide
For times when you need to borrow money, both home equity loans and personal loans get the job done. However, taking out a loan is a major decision and knowing the right one to pick for your situation can be tricky. Both loan types usually have fixed interest rates, but one typically has lower rates and the other is easier to access quickly.
Let’s compare home equity loans and personal loans and see if either loan fits your needs.
Home Equity Loans Vs. Personal Loans: The Basics
As mentioned above, home equity loans and personal loans have similar functions. Both can be used to access funds for numerous reasons, from home improvements to debt consolidation.
Read on to see how each type of loan works and when to consider either option.
How Does A Home Equity Loan Work?
A home equity loan gives homeowners the chance to tap into the equity that they’ve built into their home. To clarify, home equity is simply the difference between the worth of your home and the remaining mortgage balance. The equity allows homeowners to have and use the collateral to borrow funds.
For example, if you still owe $100,000 on your mortgage and your home is worth $250,000, you have $150,000 in equity. If you wanted to convert some of that equity into cash, you could apply for a home equity loan. But most lenders require you to leave a certain amount of equity untouched, so you wouldn’t be allowed to use the total $150,000.
Home equity loans are also often referred to as a “second mortgage,” which means that you will need to pay closing costs and potentially have a home appraisal done. While home equity loans may be considered less risky, if you’re unable to pay back the loan, you will have a second lien on the property and going through foreclosure is possible.
When To Use A Home Equity Loan Instead Of A Personal Loan
Home equity loans are a great option for homeowners with a low-interest mortgage who don’t want to go through a full refinance but want to borrow some of the home equity they’ve built.
Because this type of loan is based on the value of your home, they’re not designed with newer homeowners in mind. This is due to the fact that how much homeowners can borrow is linked to their loan-to-value ratio (LTV), which is based on your equity. Lenders will look at the potential homeowner’s debt between the mortgage and the equity loan to ensure that the debt total is less than the home’s current market value.
If you’re currently underwater on your mortgage or only have a small amount of equity built up, a home equity loan might not work for your situation.
To help you consider whether a home equity loan is the right fit for you, here are some pros and cons for this type of loan.
Pros | Cons |
|---|---|
Lower interest rates | Closing costs make this an expensive way to borrow, particularly for modest sums |
Interest is tax deductible if the loan is used to improve the home | Risk of foreclosure |
Repayment time terms are more flexible | Limits on how much homeowner can borrow
|
How Does A Personal Loan Work?
Like home equity loans, personal loans give borrowers an opportunity to use a lump sum of money that must be repaid with consistent monthly payments. Unlike a home equity loan, a personal loan is an unsecured loan that has no collateral, which means that there is nothing of value securing the loan.
Instead, a borrower’s ability to secure a personal loan will depend on their income, debt-to-income ratio (DTI) and credit score – essentially, a borrower’s creditworthiness. Typically, a credit score of at least 650 can help a borrower obtain a personal loan with a good interest rate.
Since there is no collateral involved with personal loans, the time frame to get a personal loan is much faster than home equity loans but the repayment period can range from a year to around 6 years. Keep in mind that the longer the term, the higher the interest rate will be.
When To Use A Personal Loan Instead Of A Home Equity Loan
Personal loans are a great option for borrowers who don’t want to use their home as collateral or perhaps don’t have enough equity built up to get the loan amount they need. As personal loans are unsecured, you won’t have to worry about foreclosure if you fall behind on your payments, although you’ll likely experience other negative side effects instead.
Personal loans are also an excellent choice for borrowers with great credit history and stable income. That’s because lenders will assess your financial situation to determine whether you qualify for the loan.
Thinking that a personal loan may be the right fit for you? Let’s look at some pros and cons of using a personal loan.
Pros | Cons |
|---|---|
Faster payout than home equity loans | Generally higher interest rates |
Main costs is an origination fee in most cases | Borrowers must have good credit |
Cost of borrowing is lower for smaller borrowing amounts | Will negatively impact DTI ratios |
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Home Equity Loans Vs. Personal Loans: The Key Differences
Now that you know how each type of loan works along with their pros and cons, let’s go over their eligibility requirements and how they differ. We’ll also explain each criteria in more detail down below.
| Home Equity Loan | Personal Loan |
|---|---|---|
Credit score | 620 – 680 | 610 – 640 |
Debt-to-income ratio | No more than 45% | No more than 36% – 50% |
Collateral | Secured by your home | No collateral required |
Loan Amount | Most lenders don’t allow borrowers to use more than 85% of their equity | Most lenders only loan up to $45,000 or $100,000 in some rare situations |
Closing costs | 2% – 5% of the loan amount | 1% – 10% of the loan amount |
Repayment terms | 5 – 30 years | 12 – 60 months |
Time to fund | 2 – 4 weeks | 1 – 7 business days |
Credit Score
The minimum credit score required for a home equity loan or personal loan depends on the lender you use. But in most cases, a FICO® Score of 620 will qualify you for a home equity loan. However, applying with a higher score may grant you access to lower interest rates and longer terms.
Similarly, most personal loan lenders require a minimum credit score in the mid-600s, but you may qualify with a lower score if you have a stable income or use a co-signer. Unfortunately, not all lenders will accept co-signers.
Debt-To-Income Ratio
A debt-to-income ratio is a comparison of your gross monthly income against your monthly debts. Lenders typically use this metric to determine if you can afford your monthly loan payments. If you have a DTI over 45%, you might not qualify for a home equity loan.
If you have a DTI over 36%, you might have a harder time getting approved for a personal loan. Although, there are some lenders that may accept a DTI as high as 50%, depending on your personal circumstances.
Collateral
An important differentiation between home equity loans and personal loans is that one is secured and one is unsecured. Because a home equity loan is a secured loan, the lender views your equity in your home as the asset to back the loan. If the loan is not repaid, the lender can foreclose on the home.
As an unsecured loan, a personal loan is not backed by collateral. Different lenders have varying requirements, but unsecured loans typically require excellent credit and a secure income. If the borrower is unable to pay the loan back, their credit can be severely impacted.
Loan Amount
Since home equity loans are secured by your home, the amount of equity you have directly impacts how much you can borrow. Most lenders only allow homeowners to use up to 85% of their home value. For instance, if your home is worth $200,000 and you do not currently owe any outstanding mortgage balance, you can only borrow up to $170,000.
On the other hand, personal loan amounts are mainly determined by your income, DTI ratio, credit score and the lender’s limits. In most cases, you can only borrow up to $45,000, though some lenders may allow you to borrow up to $100,000 in rare cases.
Closing Costs
The cost to obtain a home equity loan or a personal loan are different, due to the nature of each loan. While the closing costs for a home equity loan are less than the costs would be for a standard mortgage, they still cost 2% – 5% of the loan amount. The closing costs can include an origination, credit report, title or even an appraisal fee.
A personal loan’s cost is much lower, as lenders only charge an origination fee. These are an upfront cost to start a new loan application to cover any underwriting or verification fees. The origination fee is determined by the percentage of the original loan amount for the services required to get the loan.
Repayment Terms
Home equity loans typically come with longer repayment terms than a personal loan. That’s because home equity loans, as a type of second mortgage, are designed to be a long-term form of financing.
Personal loans are instead considered to be a short-term form of financing. In most cases, lenders will only use terms between 12 – 60 months, but you may be able to get a term as long as 72 months if you have good credit.
Time To Fund
The last major difference between home equity loans and personal loans is the time it takes to receive funding. Home equity loans can take up to 4 weeks to get approved and for lenders to deposit the lump sum. This timeline includes having to submit the application and for your home to be appraised.
A personal loan, alternatively, only takes a few business days to be processed and a few more for the funds to be dispersed. Some lenders may even offer same day financing, meaning the borrower can receive their funds on the same day their application was approved.
Alternatives To A Personal Loan Or Home Equity Loan
If neither a personal loan or home equity loan seem like the right solution for your needs, you can also consider these alternatives:
- Home equity line of credit (HELOC): If you have plenty of home equity, but not sure what dollar amount you need to complete your project, a HELOC might be the perfect option. A HELOC works like a credit card but is secured by the equity you have in your home.
- Cash-out refinance: If you’re a homeowner with equity and want to change your mortgage’s interest rate or repayment term, a cash-out refinance may work better than a home equity loan or personal loan.
- Balance transfer credit cards: If you want to consolidate your debt but don’t want to use a personal loan, you can opt for balance transfer This works by transferring multiple credit card balances to a single new credit card, streamlining your payments.
Personal Loans Vs. Home Equity Loans: FAQs
Still can’t decide between a home equity loan and a personal loan? Learn more about them with the answers to these common questions.
Is a home equity loan or personal loan better?
A home equity loan isn’t always the better option and vice versa. For some borrowers, a personal loan might be better and for others, a home equity loan might be the best choice. It mainly depends on your personal situation.
For example, if you have equity you want to use, a home equity loan can help you convert it into cash. However, a personal loan could be better if you have good credit, a steady income and don’t want to use your home as collateral.
What is the main difference between a home equity loan and personal loan?
The primary difference between a home equity loan and personal loan is that a home equity loan is secured while a personal loan is unsecured, meaning the borrower doesn’t need to use their home to secure the loan. But keep in mind, because a personal loan is unsecured, they may come with higher annual percentage rates (APR).
Can I use a home equity loan for personal reasons?
Yes, you can use the funds from your home equity loan for almost any reason. You can pay for a home improvement project, fund a vacation or pay off debt. Just make sure you can repay the loan before using this form of financing.
The Bottom Line: Homeowners Have Borrowing Options
Everyone has a different financial story. Whether you have good credit, you have significant equity in your home or you need money for an emergency, the loan that you choose depends on you and your needs. By understanding the basics of both home equity and personal loans, you can decide which borrowing option fits your financial story. You can borrow against your home equity, if you have it, or borrow against your credit with a personal loan.
If you decide to get a home equity loan, you can apply online now to get the process started.
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