Personal Loan vs. Home Equity Loan: Which Is Better?
CS
Summary:
Both personal and home equity loans are popular installment loans people often use to cover expenses such as medical bills or purchasing a car. Personal loans are best for short-term expenses and are paid back in a few years. Home equity loans are better for long-term expenses and are paid back over as much as 30 years.
Life is full of all kinds of unexpected — and sometimes expensive — events. No matter how much you plan ahead, there may come a time when you will have to borrow money. Home equity loans and personal loans are two popular types of loans that people turn to when they’re in need of some extra cash. Both are installment loans and are often used to cover the same purchases.
For all their similarities, there are several important differences between personal and home equity loans. So, it’s likely that one will be a better fit for your circumstances than the other. It is important to understand the differences between the two before you dive into a loan you may not understand. Here, we outline the traits of each and when it might be better to choose one over the other.
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What are personal loans and home equity loans?
Both personal loans and home equity loans are installment loans that can be used to cover many of the same expenses. Whether it’s something serious like a medical expense or something fun like a vacation, one of these loans will likely cover it. Both loans also give the borrower a lump sum upfront. Borrowers pay them back in fixed monthly payments with interest rates over a set amount of time.
But these loans do differ in some important ways. For instance, personal loans are generally better for those who need a smaller loan, while home equity loans are good for those who have something quite expensive they need covered.
Here are some other things you need to know about personal loans vs. home equity loans.
Home equity loan
Home equity is what your home is currently worth, minus what you owe on it. With a home equity loan, you borrow against your home equity. In other words, you borrow against your home’s current value. Borrowers generally use home equity loans to cover large expenses, such as medical bills or home renovations. Home equity loans usually have interest rates that are lower than those of a personal loan. Home equity loans are also referred to as second mortgages. Your house serves as collateral for a home equity loan. This means that, if you default, the ownership of your home could be in danger.
Personal loan
Personal loans are unsecured loans, meaning your property does not serve as collateral. Instead, defaulting on a personal loan will result in a significant drop in your credit score. Lenders give individuals personal loans based on their creditworthiness. This means you will likely need a good credit score in order to receive a personal loan.
Banks, online lenders, and credit unions offer personal loans. The approval turnaround can be quite quick and easy, especially compared to home equity loans.
How home equity loans work
To decide if they’ll give you a loan, lenders typically look at your equity, credit score, income, and loan-to-value ratio. The lower the loan-to-value ratio, the lower your interest rate will be. With home equity loans, you are borrowing against your home’s equity. A home’s equity is the current value of the home minus how much you owe on your mortgage.
You’ll receive the loan amount in a lump sum payment. Borrowers pay back home equity loans in fixed installments, usually over a period of between five and 30 years. You typically have to make a monthly loan payment with a fixed interest rate over the term of the loan. If you do not make these payments, you could face foreclosure and loss of your home.
How personal loans work
You will receive a personal loan based on your creditworthiness. A lender will review your credit history, credit score, and income when determining whether or not to offer you a loan. Your credit score will also determine the interest rate of the loan. The higher the credit score, the better the interest rate will be. Once approved, you could receive a loan amount of $12,000 to $15,000. This amount could be deposited into your bank account within a few days of when you apply. You will be expected to pay back this amount as monthly payments within a few years.
What can these loans be used for?
What you can use a home equity loan or personal loan for can vary by lender, but here are several common uses for these loans:
How to use your home equity or personal loan
- Consolidate debt
- Cover medical expenses
- Ensure you have emergency funds on hand
- Fund a student loan
- Pay for investments
- Fund a vacation or celebration, such as a wedding
- Purchase an expensive item, such as a car
- Pay off or reduce credit card debt
- Start a business
- Renovate or upgrade your home
Again, your options may vary by lender. One lender may approve a home equity loan so you can consolidate debt, while another may want you to use a personal loan for that purpose. Talk to lenders to see if they would approve your desired loan for the reason you need.
Personal loan vs. home equity loan: the pros and cons of each
Both personal loans and home equity loans have advantages and disadvantages. Before choosing which loan to go with, be sure to look at the pros and cons of each. We have laid out several for you here:
Which loan is right for me?
Home equity loans are better for big, long-term expenses. So, if you need a large sum of money to cover something like a medical expense or home renovation, then a home equity loan may be the best choice for you. Home equity loans allow you to pay back these pricey loans over a long period of time. But, remember, your home will be used as collateral in this instance, so be sure you will be able to pay it off.
For short-term expenses, such as funding a vacation or buying new furniture, a personal loan may be the better option for you. For one thing, lenders tend to approve personal loans faster than home equity loans. So, if you need a loan fairly quickly, a personal loan may be the route to take. But, remember, you’ll only have a few years to pay off a personal loan, as opposed to the many years you’d have to pay off a home equity loan.
Alternative options to these loans
Perhaps you don’t qualify for a personal loan or a home equity loan. The good news is that you have many options. Here are a few other choices you have if you aren’t able to get a home equity or personal loan:
Cash-out refinance
A cash-out refinance is when you apply for a new home loan that has a larger balance than your current one. This new loan pays off your existing mortgage, replacing it with a new one. You receive the leftover money in a lump sum. This new mortgage can have a new loan term and interest rate. Cash-out refinances are also a great option if the current interest rates are lower than what you are currently paying.
Home equity line of credit (HELOC)
A HELOC is similar to a home equity loan in the sense that it is based on how much home equity you have. But a HELOC is like a credit card and gives you a revolving line of credit. This means that, instead of a lump sum, you receive money in smaller amounts over a period of time.
Pro tip: Reverse mortgages, HELOCs, and home equity loans all have key differences and benefits. Click here to learn more about each, and to discover their pros and cons.
Credit card
If you need to make a major purchase quickly, a credit card could be another good choice. Using a credit card can also help you earn rewards. Just be sure you can pay off the debt each month.
Unsecured personal line of credit
An unsecured personal line of credit is when you borrow a specific amount of money for a set time period. This could be a good way to go instead of a credit card, but keep in mind that the interest rates may be high due to its unsecured nature.
401(k) loan
With a 401(k) loan, you can borrow whichever is lower of the two: up to $50,000, or 50% of your balance. These loans also do not have a minimum credit score or income requirement. While this option may seem appealing for these reasons, it may not be the best choice. If you’re laid off or fired, you could have to repay all that money before tax day. Those who use this loan and are younger than 59½ will have to pay a 10% penalty and income taxes — unless they’re eligible for some exception.
[Y]you should consider a few things before taking a loan from your 401(k). If you don’t repay the loan, including interest, according to the loan’s terms, any unpaid amounts become a plan distribution to you. Your plan may even require you to repay the loan in full if you leave your job.” — IRS
Home equity investments
A home equity investment, also known as a shared equity agreement or a shared appreciation, is a financial agreement that allows another party to invest in your property and acquire a stake in its future equity. It’s important to understand that although they share some similarities, shared equity agreements are not mortgages. In fact, they aren’t technically loans. For this reason, their credit and income requirements are often lower than traditional home financing products.
With home equity investments, you won’t have to make any monthly payments on the amount, nor pay any interest. When the term is up, whether triggered by a set number of years or the sale of the home, you’ll repay your investor. How much you pay depends on whether your property’s value went up or down.
Shared equity agreements are also available for homeowners who want to liquidate part of their equity. You can receive a portion of your equity in cash and won’t have to make payments or pay interest. At the end of the term, you repay the amount plus or minus the appreciation or depreciation.
FAQ
Is a personal loan better than a home equity loan?
Personal loans are better for those in need of short-term expenses and who do not own a home. If you’re looking for something to cover more long-term costs with lower interest rates and own a home, a home equity loan is worth looking into.
Is a home equity loan a personal loan?
Though both are installment loans that offer lump-sum payments, a home equity loan and a personal loan are very different. Personal loans tend to have a higher interest rate but are approved more quickly and have fewer requirements than a home equity loan.
What are the disadvantages of an equity loan?
Your home is used as collateral in a home equity loan. One of the biggest disadvantages is, if you fail to make your monthly payments for the loan, you could lose your home through foreclosure.
Key takeaways
- Personal loans and home equity loans are both popular types of installment loans and offer lump-sum payments upfront.
- Personal loans are better for smaller, short-term expenses, while home equity loans are better for long-term, heftier expenses.
- Interest rates for a home equity loan are usually lower than those of a personal loan.
- Your home is used as collateral in a home equity loan, while only your credit score could be affected with a personal loan.
Find the best loan for you
If you’ve decided between a personal loan and a home equity loan, it’s now time to review and compare your options. There are many available, and thankfully, SuperMoney is here to help. Click here to review and compare home equity loans. To review and compare personal loans, click here.
CS
Camilla has a background in journalism and business communications. She specializes in writing complex information in understandable ways. She has written on a variety of topics including money, science, personal finance, politics, and more. Her work has been published in the HuffPost, KSL.com, Deseret News, and more.
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