If you’re looking to borrow money for a home renovation, financial emergency, or another expense, finding the right option can be confusing. Two options worth considering are home equity loans and personal loans. But which loan addresses your financial needs better?
If you’re wondering how to get a loan that works for you, it’s best to start by learning the features, similarities, and differences between a home equity loan and a personal loan.
Home equity loan vs. personal loan
Getting approved for a home equity loan — and the amount you’re eligible for — depends largely on the amount of equity you’ve built up in your home. Generally, the more home equity you have, the more you can borrow. By contrast, eligibility for a personal loan rests on your credit history and income stability.
Here are the key factors to consider when deciding between a home equity loan vs. a personal loan:
|Home equity loan||Personal loan|
|Annual percentage rate (APR)||Ranges from about 3% to 11%||Ranges from 3% to 36%|
|Maximum loan amount||Up to 85% of equity in your home||Up to $100,000|
|How funds are disbursed||One lump sum payment||One lump sum payment|
|Fees||Often 2% to 6% of the loan amount||Often 1% to 8% of the loan amount|
|Monthly payment amounts||Fixed||Fixed|
|Access to line of credit||No||No|
How do home equity loans work?
A home equity loan, also known as a second mortgage, is a loan that allows you to access the equity you’ve built in your home as collateral to borrow money. What is equity? Equity is simply the difference between your home’s value and the amount you owe on your mortgage.
Unlike a home equity line of credit (HELOC) that operates more like credit cards, home equity loans work like traditional loans. You receive your funds as a single lump-sum payment with a fixed interest rate, and you repay the balance in fixed monthly installments over a set repayment period.
Although you can use the funds for just about anything, many borrowers use their home equity loans to fund home improvement projects or pay for an emergency expense.
Home equity loans are secured loans, and they generally have lower interest rates than personal loans since the property serves as collateral on the loan. With a home equity loan, the amount you are approved for is generally based on the equity you’ve accrued in your home. Lenders commonly allow you to borrow up to 85% of your equity.
If you’re a new homeowner, you may not have had a chance to build up much equity yet, so this type of loan might not be a feasible option. But if you do have enough equity to take out a home equity loan, it could be a good option for you.
Like most loans, you’ll need a good credit score and stable income history to qualify for a home equity loan. However, another critical factor loan underwriters consider is your mortgage’s loan-to-value ratio, also known as LTV. In other words, your lender will require your combined debt from your original mortgage and the equity loan to be less than the estimated sale price of your home.
Generally, the lower your LTV, the lower the interest rate you’ll likely receive. In other words, your interest rate might be less on a loan with an LTV of 50% than it could be if your LTV is 85%, simply because the former ratio could present less risk to the lender.
Finally, lenders want to make sure you can comfortably afford your home payment, so they’ll also look closely at your debt-to-income (DTI) ratio before approving you for a loan. DTI is a metric banks use to measure your ability to repay your loan. It represents the percentage of your gross monthly income that you use for your monthly debt payments. In general, your DTI ratio will likely need to be below 43% to qualify for a home equity loan.
Home equity loans also typically have some costs to be aware of, such as fees for loan origination, appraisal, document preparation, recording, and for the broker. And even the best mortgage lenders may take up to a few weeks to process your loan because they must first evaluate your property.
Besides low interest rates, one of the most significant advantages of home equity loans is the potential tax break. According to the IRS, if you use the funds from a home equity loan to build or substantially improve the home that secures the loan, the interest could be legally written off as a tax deduction.
What to expect when you apply for a home equity loan
During the underwriting process for a home equity loan, your lender will want to know how much equity you have in your home and your debt-to-income ratio to make sure you can afford the payments. As a second mortgage, the application process may mirror the application process for the original mortgage in many ways, with a home appraisal and a lengthy closing period.
When you apply for a home equity loan, your lender will also pull your credit report. This hard credit inquiry could cause your credit score to drop by a few points. Unfortunately, hard inquiries remain on your credit report for approximately two years.
But, there are many things to consider before you get a home equity loan. Here are some of the advantages and disadvantages of these loans.
Pros of a home equity loan
- Lower interest rates: With your home’s equity serving as collateral, lenders could view the loan as less risky and might extend lower interest rates than other loans.
- Easy to qualify: These loans might be easier to qualify for than other loans because the borrower’s home serves as collateral.
- Affordability: Since the loan terms are longer than other consumer loans, the monthly payments are often smaller.
- Fixed payments: No surprises here. You’ll pay the same amount each month for the duration of the loan.
Cons of a home equity loan
- Potential for home repossession: Because your home’s equity serves as collateral, you could face a lien on your property — or worse, repossession of your home if you default on the loan.
- High minimum loans: Some lenders might require a large minimum loan amount, which could be more than you need.
- Lengthy funding timeline: The time it takes to fund your loan could be considerably longer than it would be for a consumer loan.
- Loan repayment if you sell: If you sell your home, you’ll need to repay your entire home equity loan in addition to the balance owed on your primary mortgage. This could be challenging in a down market where the value of your home might be lower than your combined loan balance.
How do personal loans work?
Personal loans are a type of installment loan. Upon loan approval, you’ll generally receive a one-time cash payment with a fixed interest rate, which you must pay back with interest in regular monthly payments during the loan’s repayment term.
Common uses for personal loans are debt consolidation, funding home repairs or upgrades, or paying for large purchases. In reality, you can use a personal loan to pay for most major purchases, usually at a lower interest rate than paying with a credit card.
According to the Federal Reserve, the average 24-month personal loan APR currently stands at 9.58%, far lower than the average credit card APR of 16.30%. Given this, you can see why consolidating high-interest credit cards with a lower-interest personal loan is a popular option.
Besides interest rates, you’ll sometimes pay an origination fee or an administrative fee with a personal loan, which is generally taken from your loan amount once your loan is approved. Ask your lender if your loan includes a prepayment penalty in case you want to repay the loan in full before the end of the term.
Since home equity loans are secured with collateral, it’s generally easier to qualify for a loan. That’s not how personal loans work. Personal loans are typically unsecured loans that do not require collateral, which means your credit score and income history might play a more important role when qualifying for a loan. Generally, the higher your credit score, the lower your personal loan interest rates.
Once a lender approves your loan, they will typically deposit the funds directly into your checking account. If you’re using the loan to consolidate your debt, your lender might also agree to pay off your creditors directly.
What to expect when you apply for a personal loan
When you apply for a personal loan, the lender will pull your credit to review your financial history. This credit pull is called a hard inquiry, which typically lowers your credit score by a few points.
As you compare the best personal loans, keep in mind that many lenders allow you to prequalify for loans, which generally results in a soft credit pull that doesn’t impact your credit score.
Pros of a personal loan
- Your home is not at risk: If the worst happens and you default on your loan, it probably won’t affect your ability to remain in your home.
- Fast approval: You can typically get a personal loan faster than a home equity loan, usually within a few days and sometimes within a few minutes.
- Better for small amounts: There’s no sense going through a full underwriting process of a home equity loan for $5,000. Personal loans tend to be better if you’re borrowing a small amount of money.
Cons of a personal loan
- Higher interest rates: Because personal loans are unsecured, they generally carry higher interest rates than home equity loans.
- Harder to qualify: Without collateral, banks might be less willing to take on risks. As such, applicants with poor or fair credit could find it more challenging to qualify for a personal loan.
- Lower borrowing amounts: You may not be able to borrow as much with a personal loan as you would with a home equity loan. Personal loans rarely exceed $100,000. On the other hand, home equity loans might allow you to borrow much more than that if you have enough equity.
Home equity loan vs. personal loan: Which is the better option?
To determine whether a home equity loan or a personal loan is better for you, consider each loan’s features as they relate to your financial situation.
Generally, a personal loan can be a good option for those who have a strong credit history and need access to the funds quickly. A personal loan could be a better option if you don’t own a home or you’re a new homeowner who hasn’t yet built up significant equity.
A personal loan might also make more sense if you own a home in an area where home prices are stagnant or falling. In this situation, it probably wouldn’t make sense to get a home equity loan if your combined mortgage balances would exceed your home’s actual value.
On the other hand, if you’re a homeowner with sizable equity in your home, a home equity loan could be worth considering. That’s especially true if you need a loan amount over $100,000, which is rare to find with a personal loan.
Which is better, a home equity loan or a personal loan?
Deciding between a home equity loan or a personal loan will come down to your financial objectives. For example, if you want higher borrowing amounts and a lower interest rate, a home equity loan might be the better bet. However, if you need a smaller amount but need the money quickly, a personal loan is likely your better option.
Will a home equity loan hurt your credit score?
When you apply for a home equity loan, you’ll be subject to a hard credit inquiry, which might cause your score to drop by a few points. It's important to note that a home equity loan won't impact your credit utilization ratio because it's an installment loan, not a revolving line of credit.
However, if you have only one type of credit on your credit reports, such as credit cards, a home equity loan could improve your credit mix, which might result in a modest bump to your credit score. As you build a positive payment history by making on-time loan payments, you could also see your credit score increase.
Will a personal loan hurt your credit score?
Similar to a home equity loan, when you apply for a personal loan, you’ll be subject to a hard credit inquiry during the loan application process. This could negatively impact your credit score.
Since a personal loan is an installment loan and not a line of credit, it won’t factor into your credit utilization ratio. However, if you use a personal loan to pay off other high-interest credit card debt, your credit utilization ratio might decrease, which could potentially help your credit score.
If a personal loan improves your credit mix, it could result in a small bump to your credit score as well. Establishing a positive payment history could help your score, too.
Is a home equity loan the same as a HELOC?
A HELOC and home equity loan are not the same. While both loan products help you access equity in your home, they are different in their structure. While a home equity loan is an installment loan with a fixed monthly payment, a HELOC works more like a credit card with a revolving line of credit.
What are alternatives to a home equity loan or a personal loan?
Other alternatives to access funds include the following types of loans and credit cards:
- HELOC: Home equity lines of credit (HELOCs) are a type of revolving credit that lets a borrower access their home’s equity. You can withdraw and repay your credit line repeatedly.
- Credit cards: Like a HELOC, credit cards are a type of revolving credit. But unlike a HELOC, credit cards are usually unsecured. And, in some instances, credit cards offer a 0% APR introductory period, which could act as an interest-free loan if you repay your full balance before the promotional period ends.
- Cash-out refinance: Cash-out refinancing allows a borrower to refinance their mortgage for an amount larger than what they currently owe. You’ll receive the additional amount as cash, minus closing costs.
When it comes to how to get a loan and which type is right for you, there isn’t a one-size-fits-all solution. If you have significant equity in your home, a home equity loan could provide a low interest option to fund a project or pay for an emergency or unplanned expense.
But your home equity isn’t your only accessible option when you need money. If you don’t want to put your home at risk and don’t need a sizable amount, a personal loan could be just what you need for your unique personal finance situation.