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How to choose between a home equity loan and a personal loan when you’re in need of extra funds

October 20, 2022, 2:39 PM UTC
Couple speaking to their accountant
Borrowing only what you need can help you reduce your long-term interest costs.
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Getting a loan is one way to cover unexpected costs or large expenditures like a home renovation, school tuition, or a down payment on an investment property.  

But there are many types of loans that can help achieve these goals, including home equity loans and personal loans. While both of these options can offer you a lump sum of cash, the two aren’t interchangeable. One is more suited for smaller loan amounts, is easier to qualify for, and may cost you more. The other offers larger sums, lower rates, and longer loan terms.

Home equity loans vs. personal loan

Home equity loans and personal loans are two ways you can borrow cash. With a home equity loan, you borrow against the equity you have in your house (the part you actually own) in exchange for a lump sum. These loans are usually issued by banks, credit unions, and mortgage lenders.

Personal loans, on the other hand, require no collateral (i.e., an asset a lender accepts as security for extending a loan) and are available through most financial institutions and lenders. 

“Personal loans are available to people who don’t own a home,” says Barry Rafferty, senior vice president of capital markets at Achieve. “Instead of home equity, lenders make decisions based on income, credit history, and debt-to-income ratio.” 

In both cases, borrowers get an upfront lump sum, plus fixed interest rates and consistent monthly payments over the life of the loan. 

Despite their similarities, though, home equity loans and personal loans aren’t one and the same. See the key differences between these two types of loans below. 

What is a home equity loan? 

A home equity loan is a loan that uses your equity stake—your home’s value, minus what you owe on it—as leverage. You then get a portion of that equity back in cash.

“You can get a home equity loan for anything from $5,000 to $500,000, depending on the limits at the financial institution,” says Nicole Rueth, senior vice president of the Rueth Team at OneTrust Home Loans. 

Home equity loans are technically a type of second mortgage, meaning they’re subordinate to your main mortgage. If you fail to make payments, your main mortgage lender has a claim to the house first, followed by your home equity lender. Additionally, home equity loans add a second monthly payment to your household (on top of your main mortgage payment).

How home equity loans work 

When you take out a home equity loan, you’ll get a lump sum payment after closing. That balance—plus interest—is spread across your entire loan term, which can range anywhere from five to 30 years. Since interest rates on these loans are fixed, your payments will remain consistent for the entire term. 

To get a home equity loan, you’ll need to be a homeowner and have paid down a fair share of your mortgage. Most mortgage lenders require you to have at least 10% to 20% equity in your home. To calculate your equity, take your home’s fair market value (you can check with your local appraisal district for this) and subtract your current mortgage balance. Then divide that number by your home’s value. For example, if your home’s worth $500,000 and your mortgage balance is $400,000, you have $100,000 in home equity—or 20%.

Beyond having equity in your home, you will also need to meet the following requirements: 

  • A 680 credit score or higher
  • A 45% debt-to-income ratio (DTI) or lower
  • No more than a 90% loan-to-value (LTV) ratio

Some lenders may approve borrowers outside these requirements, so if you’re not sure you can qualify, consider shopping around before applying. 

Pros and cons of home equity loans 

When compared to personal loans, home equity loans have some notable benefits—but they’re not perfect. Here are the pros and cons you’ll want to consider before taking one out.

Pro: They have lower interest rates

Since home equity loans require collateral, which reduces the risk the lender takes on, choosing a home equity loan over a personal loan will typically mean a lower interest rate. “A personal loan will have higher rates since it’s not liened on anything,” Rueth says.

A lower interest rate can equate to big savings over the life of your loan. If you had a five-year home equity loan for $30,000 at a 7% rate, for example, you’d pay $5,642 in interest by the end of your term. Compare that to a personal loan with the same terms and a 12% rate, and your interest costs would surpass $10,000.

Con: The application process takes longer 

One major downside is that home equity loans are slower to process, namely because the lender has to evaluate your property in addition to your financial profile. They will also require an appraisal, which can add a week or more to your timeline, depending on where you’re located. “Home equity loans take longer to get approved than personal loans,” Rafferty says. “The application process is more complex.”

Though the exact timeline depends on your lender, personal loans can sometimes take as little as just 24 hours for processing and funding. Home equity loans, on the other hand, can take up to a month or more, in some cases. 

Pro: They have longer loan terms

If you’re looking to spread your costs out over more time, a home equity loan may be beneficial. In many cases, home equity loan terms go as long as 30 years, while personal loans are six years at most. 

These longer loan terms also allow for lower monthly payments, which can help keep your household cash flow healthy.

Con: They put your home at risk

Home equity loans use your home as collateral. While this reduces the risk for lenders and allows them to offer lower interest rates, it moves much of the risk to you, the borrower. If you don’t make your payments as agreed upon, the lender can foreclose on your house. 

Another risk to think about: Taking out a home equity loan could mean having quite a large balance against your house. If home values fall in your area, you may end up owing more on the home than it’s worth. This could make it difficult to sell the home and pay off your loans.

Pro: You can borrow more

Home equity loans generally offer larger loan amounts than personal loans. Some lenders offer home equity loans of as much as $500,000.

Personal loan limits are typically much lower than this. Though it varies by lender, most personal loans max out at $100,000.

Con: Only homeowners are eligible

Personal loans consider your credit score, income, and financial details when determining eligibility. With home equity loans, all those factors, plus your home’s value and your existing mortgage balance, play a role. If you haven’t paid down your existing mortgage much—or you don’t own a home at all—you won’t be eligible.

What is a personal loan? 

A personal loan is a type of unsecured loan—meaning there is no collateral required. Instead, eligibility is based on your financial details, things like your income, credit score, history with debts, and debt-to-income ratio.

Like home equity loans, personal loans offer an upfront lump sum, and you repay the funds via monthly payments over time. Most have fixed interest rates and last for anywhere from one to six years. 

How personal loans work 

Many consumers use personal loans to pay for large expenses, like medical bills, wedding costs, home repairs, or even consolidating debt. To start the process, you’ll fill out your chosen lender’s application and agree to a credit check. Generally speaking, you’ll need somewhere between a 610 and 660 credit score to qualify, though this varies by lender.

Your score will also influence the costs of your loan. As Rafferty explains, “Rates for personal loans will vary substantially based on credit score.”

Lower credit scores usually equate to higher interest rates, while borrowers with higher credit scores enjoy the lowest rates. If you’re worried about what your current score may mean for your interest rate, talk to the bank or credit union where you have your checking and savings accounts. Some institutions offer loyalty perks, which may help save you money.

Once you’re approved for your personal loan, you’ll receive a lump sum payment from your lender. You will then start making monthly payments until the entire balance, plus interest, has been repaid. 

Pros and cons of personal loans 

There are several benefits to using a personal loan rather than a home equity loan, but drawbacks exist too. Be sure to consider these loans from both angles before moving forward with one.

Pro: They’re faster

Personal loans have fewer hoops to jump through. There’s no home appraisal, and the lender only evaluates your credit report and income—not the house or your stake in it. Typically, you can get through the process and receive your loan proceeds in just a few days’ time.

“With personal loans, many lenders allow prospective borrowers to complete applications online,” Rafferty says. “They can sometimes be approved and funded in as few as three days.”

Con: They come with higher interest rates

The biggest drawback is that personal loans have higher interest rates than home equity loans. This is because personal loans are not secured by any sort of collateral, which makes them riskier for lenders.

On a home equity loan, if you failed to make your payments, the lender would foreclose on the property to recoup its losses. Since that’s not possible with a personal loan, lenders charge higher rates to account for the added risk. 

Pro: You can borrow smaller amounts

If you only need to borrow a little, personal loans can be beneficial. “Many lenders set a minimum loan amount of $10,000 or more for home equity loans. A personal loan may be as low as $1,000,” Rafferty says.

Borrowing only what you need can also help you reduce your long-term interest costs, which is another perk to note if you only require a small amount.

Con: They have lower loan amounts and shorter terms

If you need a large amount, though, a personal loan might not work. Personal loan limits typically aren’t as high as those on home equity loans, which may go up to $500,000 with some lenders.

Additionally, personal loans have shorter terms. This means you’ll need to repay the money faster, and you’ll have higher monthly payments that could put a strain on your budget.

How to choose between the two 

When choosing between a home equity loan and a personal loan, the best choice will depend on your goals and timeline. Generally speaking, though, Rueth says she “always” recommends getting a home equity loan over a personal loan—with a few exceptions.

"If a consumer is without a home, wants a quicker process, or wants additional money on top of a home equity loan, they should choose a personal loan,” she says.

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