Personal Loan Vs. Home Equity Loan – Forbes Advisor
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When it comes to versatile, affordable and widely available loan products, itâs hard to beat a personal loan or a home equity loan. But how do you know which one to choose?
That answer depends on a number of variables, many of which have to do with your specific financial circumstances. Weâll break down the pros and cons of both loan types so you can get a better idea of which one is right for you.
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What Is a Personal Loan?
Personal loans are unsecured loans that require no collateralâsomething of value that secures the loan and the lender can repossess if you fail to repay. Mortgages, home equity loans and auto loans, where the loan is directly tied to an asset, are examples of secured loans.
You can use personal loans for a variety of different expenses, including:
- Debt consolidation
- Wedding expenses
- Home improvement
- Medical expenses
- Financing a large purchase like a boat or car
The repayment terms on personal loans range between one and seven years, depending on the lender. In general, the longer the term, the higher the interest rate. Most personal loans have fixed interest rates between 4% and 36%. Whatâs more, limits typically range from $500 to $50,000, but some providers lend up to $100,000.
Both your interest rate and the amount you can borrow depends on your credit score, income and any other outstanding debts.
How Personal Loans Work
Once you apply for a personal loan, it usually takes anywhere between a couple of minutes to a week to receive a decision, depending on your lender. Lenders typically require a minimum credit score of 660, and they may also have an annual income threshold that the borrower must meet.
If youâre approved, the lender will transfer your funds as a lump sum into your bank account, usually within a few days. Repayment starts immediately after the loan is disbursed, and you pay interest on the full loan amount, whether you use all or part of it.
Some lenders will also charge personal loan origination and prepayment fees, but this varies from lender to lender.
Related: 5 Personal Loan Requirements To Know Before Applying
When to Choose a Personal Loan
A personal loan works best if you only need to borrow a few thousand dollars and want a hassle-free loan application process. You may also qualify for a low interest rate if you have excellent credit. Whatâs more, if you donât have any equity in your home, then you wonât qualify for a home equity loan, making a personal loan the right choice.
Related: Best Personal Loans 2021
What Is a Home Equity Loan?
A home equity loan is a secured loan that uses the built-up equity in your homeâyour homeâs current market value minus the remaining mortgage balanceâas collateral. Most lenders require you to have home equity of at least 15% to 20% and a minimum credit score of 620. You can borrow up to 85% of your equity and repay it over a period of five to 30 years.
How Home Equity Loans Work
If you have at least 15% to 20% equity in your home, you may qualify for a home equity loan. Homeowners can contact their mortgage lender or other loan broker and apply for a home equity loan. At closing, youâll typically need to pay fees and closing costs between 2% and 5% of the total loan amount. Some lenders may waive these additional costs.
The home equity loan is secured by your home, making it secondary to the mortgage. The loan is then disbursed as a lump sum, and you must pay interest on the entire balance of the loan. Because your home secures the loan, the lender can foreclose if you fail to make on-time payments.
When to Choose a Home Equity Loan
If you donât qualify for a low interest rate on a personal loan and have enough equity in your home, consider a home equity loan. Because home equity loans use your home as collateral, interest rates are lower than personal loans.
If you use the proceeds for a home repair or remodeling project, you can deduct any interest paid on the home equity loan on your taxes, which is not an option with a personal loan.
Related: Best Home Equity Loan Lenders
Pros & Cons of Personal Loans
Pros of Personal Loans
- Approval takes less time compared to a home equity loan.
- Thereâs no risk of having any property repossessed by the bank if you default.
Cons of Personal Loans
- Interest rates may be high, depending on the amount you borrow and your credit score.
- Some lenders charge prepayment penalties if you repay the loan ahead of time.
- Repayment terms are shorter than home equity loans, which means monthly payments may be higher.
Pros & Cons of Home Equity Loans
Pros of Home Equity Loans
Cons of Home Equity Loans
- Borrowers who default may have their home repossessed.
- It can take a few weeks to get funds, similar to closing on a house.
- Some lenders have high minimum loan amounts, which may be more than you need.
- Closing costs are often high.
Alternatives to Personal Loans & Home Equity Loans
If you need cash, there are other options besides a personal loan or home equity loan.
Borrowers who donât need much money should consider a credit card, especially if they qualify for a no-interest financing card. These offers usually last for six months or up to 21 months. Any unpaid balances at the end of the promotional period will begin to accrue interest until fully repaid. Even if you canât repay the entire balance within that time frame, you may still pay less interest than if you took out a personal loan or home equity loan.
Credit cards also provide more flexibility because the minimum payment is almost always much lower than it would be for a personal or home equity loan. For example, if you lose your job or have an emergency, itâs easier to afford a minimum credit card payment than a personal loan or home equity loan payment.
If you need access to cash, you can take out a cash advance with your credit card. However, the card provider will usually charge a cash advance fee, usually between 3% and 5% of the transaction amount, in addition to a cash advance annual percentage rate (APR). Interest on the cash advance will start accruing immediately. Cash advance interest rates are higher than a regular credit card transaction, often up to about 30% APR.
Home Equity Line of Credit
Like a home equity loan, a home equity line of credit (HELOC) uses your homeâs equity as collateral; however, instead of a lump sum, a HELOC gives you a limit you can use on an as-needed basis.
HELOCs consist of two parts: the draw period and the repayment period. The draw period refers to when you access the funds. During the draw period, a borrower is only responsible for paying interest on the money they borrow. Once the draw period is over, usually after 10 years, the repayment period begins. The repayment period typically lasts 20 years and the borrower must make monthly payments against the borrowed principal and interest.
Like home equity loans, HELOCs come with closing, appraisal and origination fees, and you need between 15% and 20% equity in your home to qualify.
If you have a current 401(k), you can borrow from the balance and use the funds to pay off debt, go on vacation or complete a home repair. The maximum amount you can borrow is $50,000 or 50% of your vested balance, whichever is lower.
Unlike other types of loans, a 401(k) loan does not have a minimum credit score or income requirement. The interest assessed on a 401(k) loan will be deposited to your account, like paying yourself interest.
Only investors who are confident in their job security should take out a 401(k) loan. If you get laid off or fired, youâll have to repay the money on or before the next tax day. If you canât afford that, the remaining balance will count as a withdrawal. Borrowers younger than 59.5 years will owe a 10% penalty and income taxes.
If you have at least 20% equity in your home, you can refinance and withdraw excess equity in your home. You can use that cash for several different reasons, like pay off other loans, remodel your existing home or purchase another property.
When you complete a cash-out refinance, you will receive a new mortgage with a different term and interest rate. The total balance will also be higher than the previous balance, and you may wind up with a higher monthly payment if interest rates are higher now than when you first took out the loan.