Personal loans and home equity loans are popular ways to fund home improvement projects, debt consolidation and other large fixed expenses. Generally, home equity loans are larger and come with lower interest rates and monthly costs than a personal loan. Your interest payments are also tax-deductible if you use funds to buy, build or otherwise significantly improve a home.
However, the lack of collateral on a personal loan could make it an attractive choice if you need money quickly or expect a change in your financial situation over the next decade. Unlike a home equity loan, you can get your personal loan funds within a few days and won’t risk losing your home if you miss a payment.
For some borrowers, neither option is ideal — especially if you don’t know how much you need to borrow. If that’s the case, consider alternatives that give you access to a credit limit rather than a fixed sum, such as a credit card or personal line of credit.
How personal loans work
Personal loans work by giving you a lump sum of funds to spend on a personal expense, which you repay along with interest and fees. Generally, you can borrow up to $50,000 with two to seven years to pay it back. However, some lenders offer as much as $100,000 and terms as long as 10 years. Shorter terms mean that you’ll save on interest, but at a potentially higher monthly cost when compared to home equity loans.
Personal loans come with fixed interest rates that range from around 8% to 36%, though the average rate is around 12% to 16%. These rates are fixed, which means that the rate you receive is the rate you’ll pay for the duration of the loan. In addition to interest, some lenders also charge an origination fee of up to 6% of the loan amount, which it either deducts from or adds to the loan balance before you receive the funds. Other than that, the only fees you might pay are related to missed or late payments.
Though there are exceptions, personal loans are typically unsecured, which means that you won’t risk losing a personal asset if you can’t repay the loan. Your loan amount, repayment term and rate are typically based on factors like your credit score and debt-to-income ratio — rather than the value of a specific personal asset.
Dig deeper: What is a personal loan? How it works — and what to know before you apply
When to use a personal loan
A personal loan is most useful when you need funds to pay for something too big to put on a credit card but might not require another lien on your home — like a small home renovation. Another common way to use a personal loan is to consolidate debt. This involves using the loan funds to pay down or pay off credit cards and other high-interest debt, which you then repay at a lower interest rate.
Personal loans can also be useful when you need funds sooner than later. In some cases, lenders can send the funds to your bank account as soon as the next day. If you apply with your bank, you may even be able to receive the funds sooner, since you won’t have to wait for it to wire the funds to your bank account.
When to avoid personal loans
Since personal loans are unsecured, they’re generally more expensive and more difficult to qualify for than a home equity loan. While there are personal loan options available to borrowers with fair or poor credit — a credit score below around 670 — you might struggle to get approved for a competitive rate.
✅ Benefits of a personal loan
-
No collateral required
-
You can borrow as little as $2,000
-
Few or no fees
-
Slightly lower credit requirements than home equity loans
❌ Drawbacks of a personal loan
-
Higher interest rates than a home equity loan
-
Narrow range of loan terms
-
Potentially high monthly payments on large loan amounts
-
Not ideal for projects with unpredictable costs
How home equity loans work
Home equity loans work a lot like personal loans with a few key differences. In exchange for backing your loan with collateral, you can receive lower rates, larger loan amounts and longer terms than you would with a personal loan. This often translates into a lower monthly cost — though there’s a risk of increasing the total cost of the loan by choosing a term that’s too long.
How much you can borrow depends on how much equity you have in your home. Most lenders offer up to 85% of your home equity. Because home equity loan amounts can be so high, many lenders offer a wider range of terms than they would on a personal loan — as long as 30 years, in some cases. Home equity loans also typically have lower rates than personal loans, partly because the collateral (in this case, your home) offsets the risk to the lender.
While rates are fixed, the rate lenders offer tends to vary depending on the prime rate. Currently, the average interest rate on a home equity loan is around 8.5% — several percentage points lower than the average personal loan rate. On top of rates, you may need to pay to have your home appraised, and you’ll likely also pay a closing fee. Since appraisal is an important part of this process, the application can take weeks or longer for approval.
🔍 How to calculate your home equity loan amount
You can get a rough estimate of how much you’d be able to borrow by subtracting your current mortgage balance from the appraised value of your home. You can then multiply the result by a loan-to-value ratio — or LTV — that your lender offers.
Say an appraiser values your home at $350,000. You’re still paying off a mortgage on that home, which has a balance of $100,000. If you subtract $100,000 from $350,000, you get $250,000 — this is your home equity. Since most lenders offer around 85%, the maximum you’d be able to borrow with most lenders is around $212,500.
This example is typical of what you might see as a borrower: The average borrower had access to about $260,000 in equity, according to the latest Intercontinental Exchange Mortgage Monitor Report.
Dig deeper: 4 ways to get equity out of your home
When to use a home equity loan
A home equity loan can be great for covering the cost of larger projects, like a home renovation to improve your property’s worth. As with a personal loan, home equity loans are paid out as a one-time sum, and so are a good fit for when you know how much you need. They’re a particularly popular way to fund home improvement projects because, in some cases, the interest you pay is tax-deductible if you use the funds to “buy, build or substantially improve your home,” according to the IRS.
Because home equity loans attract lower rates than personal loans, some people like to use them to cover large personal expenses, such as helping to pay for a kid’s or loved one’s college tuition when student loans and scholarships aren’t enough to foot the bill. Others use these loans to consolidate higher-interest debts into one payment.
When to avoid home equity loans
Using your home equity isn’t the best idea if your financial circumstances during the loan will be difficult to predict. You should also take caution when considering tapping your home’s worth for shopping, a vacation or other nonessential spending.
Remember: While a home equity loan might be less expensive than a personal loan, home equity loans also carry more risk. If you don’t repay the funds, you could lose your home.
If there’s a chance you’ll sell your house before your term is up, look elsewhere for financing, as an existing home equity loan can complicate the selling process.
✅ Benefits of home equity loans
-
Rates are often lower than those for a personal loan
-
You can borrow $100,000 or more
-
Potentially low monthly costs
❌ Drawbacks of a home equity loan
-
If you can’t repay your loan, you risk losing your home
-
The application process can take weeks
-
A home equity loan complicates any future home sale during repayment
📝 Personal loans vs. home equity loans: How to find the best fit for your needs
If you’re not sure whether a personal loan or a home equity loan is best for your project or circumstances, ask yourself these general questions to narrow down your options:
-
How much do I need to borrow? If you need more than $50,000, a home equity loan is a better option. Not sure how much you’ll need? Consider an alternative for unpredictable expenses.
-
What is my credit score? Personal loan and home equity loan providers have similar credit requirements, and neither are a great option for poor credit. But generally, it’s easier to get approved for a secured loan than an unsecured loan.
-
How much can I afford to pay each month? The short terms on personal loans can eat into your monthly budget, especially if you’re applying for a loan close to $50,000 or $100,000.
-
When do I need the money? Personal loans are often a better choice if you’re in a time crunch and can’t wait weeks to get approved.
-
How much equity do I have? Home equity loans are typically more favorable to folks who have paid off most or all of their mortgage. However, the more debt you carry, the harder it is to be approved for either type of financing.
-
What is the loan for? If you’re funding a home improvement project and still not sure which is best, consult a tax expert to learn if the interest payments are tax-deductible.
Alternatives for unpredictable expenses
Personal loans and home equity loans both require you to have an idea of how much you’ll need to borrow when you apply. If you can’t predict exactly how much you need ahead of time, consider one of these alternatives:
-
Home equity lines of credit — more commonly called HELOCs — use home equity as collateral but give you access to a credit limit, rather than one fixed sum. You can draw funds as needed for around 10 years for your project and then repay what you borrowed once the draw period is closed.
-
Credit cards may be the simplest option for smaller expenses — especially if you can repay the borrowed amount within a month or two. If you have good credit, a new credit card with a 0% APR promotional period may be a less expensive financing option for amounts you can repay within 12 to 18 months.
-
Personal lines of credit also give you access to a credit limit that you can withdraw from as needed, without requiring collateral. Credit limits are typically higher than credit cards and give you the option to pay in cash, rather than credit.
Sources
About the writer
Anna Serio-Ali is a trusted personal finance expert who specializes in consumer and business financing. A former certified commercial loan officer, Anna’s written and edited more than a thousand articles to help Americans strengthen their financial literacy. Her expertise and analysis on personal, student, business and car loans has been featured in Business Insider, CNBC, Nasdaq and ValueWalk, among other publications, and she earned an Expert Contributor in Finance badge from review site Best Company in 2020 for her work at Finder.
Read the full article here
