One of the most important things you can do when making any personal finance decision is to remember that it’s called personal finance for a reason. We all have different financial circumstances, priorities, and goals, and what’s right for one person – or even what’s right for most people – may not be right for you. Such is the case with choosing between a home equity loan and a personal loan. As with most important financial decisions, especially those that involve borrowing money, there is no “right” answer, only the right answer for you.
Before determining what’s right for you, let’s first take a look at what each option entails and examine the key differences between the two.
Home equity loans
A home equity loan is fixed amount of money borrowed against the equity in your home. So, for example, if you owe $300,000 on a home valued at $500,000, a home equity loan enables you to borrow against that $200,000 in equity. Home equity loans are fixed-rate installment loans, meaning they’re repaid in equal monthly payments over a fixed period of time – usually in the neighborhood of 15 years. While they’re commonly used to finance home improvement projects, borrowers are free to spend the money on whatever they choose, including education costs and debt consolidation.
In many ways, a home equity loan functions similarly to your original mortgage loan, and is often referred to as a second mortgage. Like a mortgage, home equity loans are secured against the borrower’s home. You can apply for and receive a home equity loan from most banks, mortgage companies and credit unions. Many apply for a home equity loan from the same lender that provided their mortgage, but you’re free to shop around for the best offer.
Remember, too, that a home equity loan is not to be confused with a home equity line of credit, or HELOC. Though a HELOC is likewise money borrowed against the equity in your home, it functions as a revolving line of credit, much the way a credit card does. Your lender sets a credit limit based on the equity in your home, and you can borrow against that limit at any point while the line of credit it still open. Because it’s a revolving line of credit and not an installment loan like home equity and personal loans, let’s set HELOCs aside for this comparison.
Rapidly emerging as an alternative to home equity loans, personal loans are direct-to-borrower loans that are not secured by collateral such as a home or automobile. Often referred to as unsecured loans, personal loans are typically fixed-rate loans, and, like home equity loans, involve borrowing a lump sum of money to be used at the borrower’s discretion and repaid in equal installments over a defined period of time. Interest rates on personal loans are typically determined by a borrower’s credit score and history. Some traditional financial establishments such as banks and credit unions offer personal loans, but there’s also a growing market of non-traditional personal loan providers such as online and peer-to-peer lenders.
Understanding the differences and trade-offs
Though they share some similarities, there are key differences between home equity loans and personal loans. As noted earlier, home equity loans are secured against the borrower’s home, so, just as is the case with your mortgage, if you default on your home equity loan, your lender can foreclosure on your home. Personal loans, on the other hand, are usually unsecured, so, while failure to make your payments on time will adversely impact your credit, none of your personal property is at risk.
Because they’re secured against your home, however, home equity loans usually feature lower interest rates and longer loan terms than personal loans. In addition, provided you have the necessary equity, you can usually borrow more money with a home equity loan than you can with a personal loan. Personal loan amounts tend to cap out in the neighborhood of $100,000, whereas home equity loan amounts are limited only by the available equity in your home. In other words, the trade-off for the peace of mind that comes with unsecured debt is usually a smaller loan amount and a larger monthly payment.
Speaking of trade-offs, though home equity loans may deliver lower interest rates, (generally starting slightly north of the going mortgage rate), the application process is typically far more arduous than that of a personal loan. For starters, you’ll need to arrange and pay for an appraisal of your home to determine the available equity. That won’t be the only upfront cost either, as you’ll incur a variety of application costs and processing fees, just as you would with a traditional mortgage. It all adds up not only to higher upfront costs, but a longer process and thus a longer wait for your money. From start to finish, the process of securing a home equity loan can take weeks or longer. By comparison, some personal loans process in days or less.
Advantages to each
So, to recap, the typical advantages of a home equity loan include lower interest rates, longer loan terms, lower monthly payments, and, provided you have necessary equity, the ability to borrow larger amounts of money.
Personal loans, on the other hand, have advantages of their own, including what is usually a faster and less stressful application process, lower – if any – upfront application costs or fees, and the peace of mind that comes with not having to put your home up as collateral.
If you have significant equity in your home, have the cash needed to pay upfront fees, and are willing to navigate a longer and more tedious loan process, a home equity loan is likely your best choice, as it will usually yield a lower interest rate, longer loan term, and lower monthly payment. Likewise, if you need a sizable amount of cash (think north of $100,000) and have the requisite equity, a home equity loan is probably the way to go.
On the other hand, maybe you don’t have equity in your home, or you just don’t want to drain the equity you do have. Maybe you’re not interested in having another lien against your home. Maybe you need the money fast, in days as opposed to weeks. Or maybe you just plain don’t want to deal with the hassles of a more traditional loan process. If any of those things apply to you, then a personal loan might be just what you need, especially if you have excellent credit and can score an interest rate comparable to what you would get with a home equity loan.
All of which to brings us back to where we started, for the verdict really is that most boring of answers: it depends. Fortunately, it depends on something you know better than anyone else – you. Focus on what’s right for you, based on your specific situation, and the “right” answer is sure to follow.