If you’re in need of a considerable chunk of money for purposes such as debt consolidation, emergency expenses, or home renovations, you’ve likely been busy researching the best type of loan for your situation.
Two popular options are personal loans and home equity loans. Both give you cash upfront with flexible repayment terms. But they vary in several important ways. Let’s look at the differences between a personal loan and a home equity loan—and help you to decide which suits your financial goals.
What is a personal loan?
A personal loan is an installment loan that gives you a chunk of money upfront. You can open a personal loan with many banks, credit unions, and online lenders and use the money for (nearly) any purpose. If it’s a legal transaction, there are very few guardrails for how you can use your funds.
When you open a personal loan, you’ll automatically be given a repayment plan of equal monthly installments until the loan is paid off. Interest is baked into each payment. The size of your monthly installment will depend on the amount you’ve borrowed, the length of your repayment term, and your unique interest rate.
Most personal loans are “unsecured,” meaning you don’t need to provide collateral to be approved. The lender will instead examine details like your credit score, debt-to-income ratio, etc. to decide if you’re creditworthy.
Pros and cons of a personal loan
Pros
- No collateral requirement
- Use your funds for just about anything
- Loan doesn’t count against your credit utilization
Cons
- Occasional ancillary fees
- Repayment terms not as generous as some other loan types (such as home equity loans)
- Often capped at $100,000 borrowing limit
What is a home equity loan?
A home equity loan (also referred to as a second mortgage) is similar to a personal loan in a few ways. You’ll receive a lump sum upon opening an account and you’ll be automatically enrolled in equal monthly installments (which include interest) until you’ve repaid the loan.
However, opening this loan type is more involved than a simple personal loan.
First, you must be a home owner who has built equity in your property. Equity is simply the value of your home minus the amount of your mortgage. For example, if your home is worth $300,000 and you still owe $125,000 on your mortgage, you’ve got $175,000 in equity.
Many lenders stipulate that you can borrow up to 80% of your home’s equity (with perhaps some rare exceptions). This means that you must keep at least 20% of your home equity invested in your property. In other words, you can’t borrow equity unless you’ve built more than 20% equity, in most cases.
With the aforementioned $300,000 property, you’d need to maintain at least $60,000 in the home. That means you could borrow $115,000 from your current $175,000 in equity.
Opening a home equity loan is a process. In most cases, you’ll need to initiate a home appraisal, present documents to be reviewed, wait for underwriting and approval, and eventually sign closing documents. It’s similar to taking out a mortgage.
Pros and cons of a home equity loan
Pros
- Interest rates are generally lower than many other types of loans
- Potentially borrow more than you could with a personal loan
- Lengthy repayment terms
Cons
- Your home is used as collateral
- The approval process is comparatively lengthy
- Minimum equity requirement
Personal loan vs. home equity loan: Side-by-side comparison
How to decide between a personal loan and a home equity loan
Again, personal loans and home equity loans are two of the most effective ways to finance a large purchase, consolidate debt, etc. But which is right for you?
Ask yourself the following questions to quickly decide.
Are you willing to put up collateral?
Perhaps the biggest differentiator between a personal loan and a home equity loan is the risk involved. Of course, you don’t want to default on any loan—but the stakes are higher with a home equity loan, as the lender can ultimately foreclose on your home.
How quickly do you need the funds?
If you’ve got an emergency expense for which you need cash quickly, a personal loan may be your only option. Several lenders boast the ability to transfer funds to your account within a day or two of account approval.
Meanwhile, home equity loans often take weeks to deposit due to the lengthy process involved—from home appraisal to underwriting to closing documents.
How much money do you need?
Most personal loans are capped at $100,000. If you need more than that, you may find a home equity loan more accommodating, as you can borrow equity equivalent to 80%-85% of your home’s value. Depending on the value of your home, and the amount of equity, you may be able to borrow hundreds of thousands of dollars.
That said, if you’ve built little equity in your home, a personal loan may provide a higher borrowing limit.
How quickly can you pay back the money?
Your repayment term is more than simply a time frame for paying back a loan; it dictates the size of your monthly installments.
For example, if you borrow $30,000 with a 10% APR, you’ll pay around:
- $968 per month with a 3-year term
- $637 per month with a 5-year term
- $290 per month with a 20-year term
While most lenders offer a maximum term length of 84 months, home equity loan terms can be up to 30 years. The answer as to which type of loan is best for you may depend on the amount of money you can pay each month.
It’s worth noting that the longer you take to pay off a loan, the more interest you’ll pay. But just because you’ve got a 20+ year term doesn’t mean you can’t pay off your loan early (and avoid considerable interest).
How much interest are you willing to pay?
All else being equal, home equity loans tend to come with lower APR. If after answering all the above questions you’re still undecided, go with the loan that offers the more reasonable interest rates.
Other ways to finance a purchase
There are more ways than a personal loan and a home equity loan to finance a purchase. Here are a few other popular options:
- Credit card: Great for everyday purchases, credit cards are a poor choice for financing a large expense for which you can’t soon pay off. That’s because their interest rates are often considerably higher. Still, some cards offer 0% intro APR for a year or two—which can potentially save you even more money than a personal loan.
- Home Equity Line of Credit (HELOC): A cross between a credit card and a home equity loan, a HELOC allows you to open a revolving line of credit by drawing on your home equity.
- Buy Now Pay Later (BNPL) options: If your purchase is manageable enough to be paid off within a few months, a BNPL service may be a good option. These split your purchase over several interest-free payments.
- Borrow from a friend or family member: Borrowing from friends and family instead of taking out an interest-incurring loan can be a huge money-saver.
Frequently asked questions
What is the main difference between a personal loan and a home equity loan?
The main difference between a personal loan and a home equity loan is that a personal loan is unsecured and a home equity loan requires that you use your home as collateral. If you default on your home equity loan, you could lose your house.
Which has lower interest rates: personal loans or home equity loans?
Home equity loans (and most secured loans, for that matter) tend to have lower interest rates than personal loans.
What credit score do you need for a personal loan vs a home equity loan?
To qualify for a personal loan, you’ll generally need to have a credit score of at least “fair” (580+), while most home equity loans require a score of 620+. Just note that a low credit score can adversely affect your interest rates, borrowing amount, and even term length. If you can, it’s better to wait and open your loan when you’ve got a credit score in the 670+ range.
Are there tax benefits to home equity loans vs personal loans?
There are tax benefits to home equity loans depending on how you use them (home improvement, for example). Personal loans are not tax deductible.
Do personal loans or home equity loans have better repayment terms?
Home equity loans have potentially longer repayment terms, giving you more flexibility in the size of your monthly installments.
