Personal Loan vs. Home Equity Loan: Which Is Best?
It’s important to take your time to choose between a personal loan and a home equity loan. Opting for the optimal loan type can go a long way in improving your borrowing experience.
Here are the main differences between personal loans and home equity loans.
- A personal loan is better for short-term needs
- Home equity loans require you to use your house as collateral
- Failing to repay a home equity loan can result in foreclosure
- The rates of personal loans depend on your creditworthiness
- The loan amounts of home equity loans depend on your collateral value
If you need extra money for a large purchase or emergency expenses, a loan could be a good idea. Finding the most suitable type of loan can help you save money and enjoy a better borrowing experience.
Personal loans and home equity loans are two popular installment loan options with fixed interest rates and repayment periods. In this guide, we’ll go over the different pros and cons of personal loans and home equity loans.
Definition and basics of each loan type
A personal loan is an unsecured loan mainly based on creditworthiness and financial stability. If your loan application is approved by the lender, you will receive loan funds as a lump sum directly disbursed into your bank account. You will then be expected to repay the loan through fixed monthly installments until the repayment period ends and the principal balance plus interest is paid.
Personal loans typically have fixed interest rates and loan terms. The loan agreement you sign will designate the interest rate and loan tenure. Personal loan interest rates usually range between 6 and 36 percent. The better your credit score, the lower the interest rate you can obtain.
Home equity loan
A home equity loan is a secured loan that uses your home equity as collateral. Home equity loans usually have fixed interest rates and loan terms. Home equity loans have an average interest rate ranging between 8 and 9 percent. The amount you can borrow depends on the value of your property, which needs to be appraised by a professional chosen by the loan provider.
A home equity loan can last for decades. Like a personal loan, you would need to pay fixed installments each month, which includes the principal balance plus interest, until the debt is paid off.
1. Collateral requirement
Personal loans usually don’t require any collateral. They are unsecured loans. This can reduce your risk as a borrower since you won’t need to offer valuable assets as collateral. Defaulting on an unsecured personal loan won’t lead to the lender repossessing your home.
On the other hand, home equity loans expect you to offer your home as collateral. If you default on a home equity loan, it can lead to foreclosure.
2. Loan amounts
Having collateral can increase the loan amount a lender is willing to offer you. Personal loan providers base each borrower’s minimum and maximum permitted loan amount on individual creditworthiness. You can typically find personal loans ranging from $1,000 to $100,000.
The loan amounts of home equity loans depend on the value of your collateral. The higher the value of your home, the more you can borrow.
3. Interest rates
Home equity loans generally have lower interest rates than personal loans because you’d be securing the home equity loan with collateral.
If you want a loan with as low an interest rate as possible, going with a home equity loan and offering high value property as collateral could be the way to go. This would let you obtain a large loan amount without needing to pay significant interest over the loan term.
4. Loan terms
The loan tenures of personal loans are highly variable depending on your needs. Personal loans can last anything from a few months to 7 years.
Home equity loans can last anything from a few years to 30 years. This long loan tenure gives borrowers plenty of time to gather the money necessary for debt repayment.
In general, a longer loan tenure means you will end up paying more in interest. This higher cost of borrowing makes many borrowers try to pay off their debt as soon as possible, opting for reduced loan tenures when possible.
5. Tax implications
If you decide to take out a home equity loan, you may be able to benefit from tax deductions. As of this guide being written, home equity loans can be tax deductible. However, tax laws change, so make sure you’re aware of the most up-to-date information on tax deductions.
Advantages of each loan
No risk to property: With a personal loan, you won’t need to use your house as collateral. Unsecured personal loans don’t require any collateral to obtain.
Quick application and approval: The personal loan application process is convenient and accessible. It can be done either online or in person.
Flexible fund usage: Personal loans are well known for allowing flexible use. They’re commonly used for debt consolidation, home improvement, medical bills, vehicle repairs, weddings, and other major purchases.
Potential credit improvement: Paying your personal loan off properly can boost your credit score over time. An active loan account in good standing shows other creditors you have good financial capability and debt management skills. Installment loans can be helpful for those in need of both financing and credit-building opportunities.
Home equity loan
Lower interest rates: Since you’re putting up your home as collateral, the lender is assuming less risk for lending you money. This results in generally lower interest rates, which can help you save a substantial amount in the long run.
Larger loan amounts: Home equity loan providers are often willing to grant larger loan amounts. If you’re looking to finance a major project or purchase that is very expensive, a home equity loan might be the better choice. A home equity loan allows you to obtain both smaller loans as well as larger loans over $100,000.
Possible tax benefits: The interest on home equity loans is currently tax deductible. If all the IRS guidelines are met and you itemize your tax deductions, you should be able to deduct the home equity loan interest.
Disadvantages of each loan
Higher interest rate: A personal loan might have higher interest rates, especially if you have poor credit. This means that as you repay the loan in fixed installments, you can end up paying more interest over time.
Lower borrowing limits: Personal loan lenders will grant you a maximum loan amount based on your creditworthiness. In general, you won’t be able to find a personal loan amount over $100,000 even with excellent credit.
Impact on credit: Applying for a personal loan can drop your credit score by five points with each hard credit check. After taking out a personal loan, missing a loan payment can result in up to a hundred points of credit damage.
Home equity loan
Risk of foreclosure: Defaulting on a home equity loan can result in foreclosure. This means that the lender can force the sale of your home in order to cover the outstanding debt.
Costs and fees: Home equity loans come with various fees and charges, including appraisal fees, recording fees, notary fees, closing costs, annual fees, and title search fees on top of the typical loan costs.
Longer approval process: Applying for a home equity loan can take around two months before you receive loan approval. If you urgently need funds, a personal loan is usually the faster financing option.
When to choose a personal loan
Short-term financial needs
Personal loans can be a great financing method for those facing short-term needs. If your personal loan application is approved, the funds will be quickly disbursed into your account, allowing you to tackle urgent financial expenses and responsibilities.
Smaller loan amounts
Personal loans are more suited for relatively less expensive bills than home equity loans. If you require a loan below $100,000, a personal loan is generally the better choice.
Think about whether you want to offer any valuables as collateral. An unsecured personal loan frees you from the risks and worries associated with collateral loans. However, it can make it harder to apply for larger loan amounts.
If you don’t have sufficient home equity, it will naturally be impossible to obtain a home equity loan. In this case, you might want to consider a secured personal loan. Secured personal loans allow you to offer various valuables as collateral, such as jewelry, collectibles, vehicles, property, and more.
When to choose home equity loan
Home equity loans are a good way to finance major purchases that require tens if not hundreds of thousands of dollars in funding.
Here are example use cases of home equity loans:
- Home improvement projects
- Emergency medical bills
- Consolidating debt
- College expenses
Debt consolidation at a lower interest rate
Debt consolidation can be a helpful way to simplify your debt repayment plans and even save on interest. Since home equity loans generally come with lower interest rates, it could be an advantageous method of debt consolidation.
Consolidating your other debts using a home equity loan can help you reduce the total costs of borrowing in the long term. When rolling your debts together to consolidate them, make sure you carefully consider each debt’s repayment terms and relevant fees. For example, loan providers often impose prepayment penalties on those who try to pay off their debt earlier than expected.
Potential tax benefits
With a home equity loan, you might be able to enjoy meaningful tax benefits. A home equity loan can be tax deductible, helping you save money. Before taking out a home equity loan, check the IRS guidelines to ensure you would qualify for the tax benefits.
Factors to consider before deciding
If you have any existing debt, this can affect what kind of loan best suits your repayment capacity.
For borrowers with low income, the higher interest rates of a personal loan may result in a financial burden.
Since credit score directly affects your loan approval and rates, individuals with poor credit might want to enhance their credit scores before taking out a personal loan.
Purpose of the loan
What you plan on using the loan funds for can alter your financing choices. If you require a large amount of money, a home equity loan might be preferable. On the other hand, if you need several thousand dollars for urgent expenses, a personal loan would be more convenient and accessible.
Consider your level of willingness to put up your home as collateral. The risk of foreclosure with a home equity loan is a critical one to think about. If you end up repaying the loan successfully, then the collateral won’t matter. However, defaulting on the loan would result in you losing your collateral.
Make sure you consider the comprehensive costs of taking out either kind of loan. Here are several important loan costs to look into before obtaining a loan:
- Interest rate
- Annual percentage rate (APR)
- Prepayment penalties
- Origination fees
- Property appraisal fees
- Late payment charges
- Consequences of defaulting
- Potential impact on credit
The duration of the loan can affect your ability to repay the debt, as well as the loan terms. A longer loan term means you have more time to gather funds for debt repayment. However, it also results in more interest accruing over time. It is important to weigh the pros and cons of a shorter versus longer loan term before making your choice.
If you aren’t sure about what financing strategy to use, consider a consultation with a financial advisor or credit counselor to receive expert guidance.
Finding a suitable loan provider is an essential part of loan shopping. Check out these reputable and popular lenders to get started with finding the optimal lender for your needs.
Personal Loans Company Reviews
Recently Updated Articles