Personal Loan vs. Home Equity Loan: Which Is Better?

Article 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.

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

  1. Consolidate debt
  2. Cover medical expenses
  3. Ensure you have emergency funds on hand
  4. Fund a student loan
  5. Pay for investments
  6. Fund a vacation or celebration, such as a wedding
  7. Purchase an expensive item, such as a car
  8. Pay off or reduce credit card debt
  9. Start a business
  10. 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:

PERSONAL LOANS

Here is a list of the benefits and the drawbacks to consider.

Pros
  • Home security. Your home and property are not used as collateral with a personal loan. While defaulting on a personal loan will damage your credit score, your home is still safe.
  • Fast approval process. The approval process for a personal loan will almost always be faster than that of a home equity loan. Personal loans can be earned with less paperwork and documentation than a home equity loan.
  • Good for small loans. Some lenders won’t give you a home equity loan for a small amount of money. Personal loans, however, can be granted for a lower amount. If you need a loan for something short-term, such as a vacation, a personal loan is a great option.
Cons
  • Short repayment period. While home equity loans have a repayment period of up to 30 years, personal loans only have a repayment period of around one to six years. This could lead to a higher monthly payment.
  • Higher interest rates. Though having a better credit score could lead to a lower interest rate, interest rates for personal loans are usually higher than those for home equity loans.
  • Prepayment penalties. If you choose to repay your personal loan ahead of time, some lenders could charge you a fee.

 

HOME EQUITY LOANS

Here is a list of the benefits and the drawbacks to consider.

Pros
  • Low interest rate. The interest rate of a home equity loan is usually lower than that of a credit card or personal loan. These loans also have fixed interest rates, meaning the interest won’t change over time.
  • Tax deductions. There is a possibility that the interest on your home equity loan is tax-deductible. If you used the loan to buy, build, or improve the home that you borrowed against, then you could qualify for a tax deduction.
  • More time to pay off the loan. You’ll only have five or six years to pay off a personal loan. Home equity loans, however, can be paid off over a greater amount of time. In some cases, you can have up to 30 years to pay off the debt. This can be useful if you need to take out a lot of money for a loan, as you will also have more time to pay it off.
  • Good for large loans. If you’re in need of a large amount of cash to cover something expensive, a home equity loan could be the best choice for you. Home equity loans tend to lend a larger amount of money than personal loans do. You’ll also have more time to pay off a home equity loan.
Cons
  • Longer approval process. The approval process for a home equity loan can be lengthier than that of a personal loan. Your lender will have to review more information, and it could take more than a month to get approval.
  • Your home is collateral. Defaulting on a personal loan could lead to a worse credit score, but that could be better than defaulting on a home equity loan. Defaulting on a home equity loan could lead to foreclosure and loss of your home. This is a serious risk you should take into account before committing to this type of loan.
  • Paying closing costs. In some cases, you will have to pay closing costs for a home equity loan. Check with your lender to see if this would be the case, and how much it would cost you.
  • You’ll need enough equity in your home. A home equity loan may seem like the best choice for your situation, but if you don’t have enough equity, then it may not even be an option.

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.

Read The Definitive Guide to Cash-Out Refinancing.

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

Shared equity agreements

A shared equity agreement, also known as 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 shared equity agreements, 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.

View Article Sources
  1. 10 uses for a home equity loanUS Bank
  2. Considering a loan from your 401(k) plan? — IRS
  3. Helpful background articles from business finance and general news sites including Forbes and U.S. News & World Report, and from credit card provider Discover — Various
  4. What is a home equity loan? — Office of the Comptroller of the Currency
  5. What is a personal installment loan? — Consumer Financial Protection Bureau
  6. Are Personal Loans Tax Deductible? — SuperMoney
  7. Best Home Equity Loans — SuperMoney
  8. Best Personal Loans — SuperMoney
  9. Home Equity Loan vs. Line of Credit: Which Should You Choose? — SuperMoney
  10. How Long Does It Take to Get a Home Equity Loan? — SuperMoney
  11. Is It Wise To Use A Home Equity Loan For Debt Consolidation? — SuperMoney
  12. Reverse Mortgage vs. Home Equity Loan vs. HELOC: Pros & Cons — SuperMoney
  13. The Best Shared Equity Alternatives to a Home Equity Loan — SuperMoney
  14. The Definitive Guide to Cash-Out Refinancing — SuperMoney
  15. What Are The Most Popular Types of Credit? — SuperMoney