Emma Finnerty
If you need to borrow money, you probably want to do so in the smartest way possible. For those who own a home, two reasonable options usually become quick contenders. Personal loans and home equity loans both give you the ability to borrow the money you need, but which one is right for you? It usually depends on your specific situation.
Here’s what you need to know about personal loans and home equity loans to decide for yourself.
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What Is a Personal Loan?
A personal loan is typically an unsecured loan. This means you don’t put up any collateral to borrow the money you need. Personal loans often last anywhere from one to eight years. However, you can sometimes find shorter or longer options, depending on the lender.
Interest rates vary but can be as low as 4 percent for those with stellar credit or as high as 36 percent for those with bad credit. Each lender has its own loan amount ranges. That said, you can find lenders that offer these loans for as little as $1,000, while some offer loans for over a $100,000.
Most lenders allow you to use the funds from a personal loan for almost anything. However, if you say you’re consolidating debt, some lenders will require you to have the funds sent directly to the lenders that hold the debt you’re consolidating.
What Is a Home Equity Loan?
A home equity loan is a secured loan that requires you to put up the equity of your home as collateral for borrowing the money. Equity is simply the difference between how much you owe on your home and what your home is currently worth.
Most lenders require you to pay for an appraisal to determine the current value of your home.
The approval process can be slow and require you to pay substantial fees to take out the loan.
Lenders also typically require you to have at least 80 percent equity remaining in your home after you’ve borrowed money through a home equity loan.
These loans usually have relatively low interest rates, depending on your credit and the current interest rate market. You could get rates as low as 5 percent if you have amazing credit, but rates can go higher. That said, they currently max out around 10 percent for most borrowers.
The repayment terms on these loans can vary from as short as five years to as long as 30 years. You can use the proceeds from the loan for pretty much anything you wish.
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Pros and Cons of Choosing a Personal Loan
There are plenty of good reasons to choose a personal loan over a home equity loan.
“As unsecured debt, a personal loan is more accessible to borrowers who don’t own property they can use as collateral,” says Elyssa Kirkham, personal loan expert and founder of Brave Saver. “A renter, for example, won’t have the option a homeowner would to borrow funds through a home equity loan. But both a renter and a homeowner could get a personal loan.”
If you can pay the loan off quickly, the higher interest rates that personal loans usually carry won’t be that big of a deal. Choosing a personal loan could allow you to get the funds much faster, since no appraisals or other major paperwork has to be done. Personal loans typically come with lower fees than a home equity loan, too.
The fact that personal loans are unsecured could make a dramatic difference in your life.
“You don't have to put up any of your own assets or property as collateral on the loan. This means that if you fall on tough times and are missing personal loan payments, it won’t put you at risk of losing your home or your car,” Kirkham says.
Personal loans aren’t always the better choice, though. They can come with interest rates that are much higher than home equity loans due to the fact the banks have no collateral.
Plus, since personal loans come with shorter repayment terms, they usually come with higher payment amounts, even if you’re borrowing the same amount of money.
Qualifying for a personal loan may be difficult, too.
“Most lenders won’t consider applicants with credit scores below the mid-600s,” Kirkham says.
“And if you are approved with a credit score in the range of around 650 to 700, you’re likely to face higher interest rates that might be nearly as bad as what you’d pay on a credit card,” she adds.
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Pros and Cons of Choosing a Home Equity Loan
A home equity loan can be a better option than a personal loan in some cases. Home equity loans will usually have lower interest rates than an unsecured personal loan.
“For larger purchases, such as investing in another property, the home equity loan could be very cost-effective,” says Brandon Renfro, an assistant professor and financial planner in Hallsville, Texas.
Due to lower interest rates, you may be able to save money on interest payments. Home equity loans typically have longer repayment terms, too, which means your payments will be lower. This can offer you more flexibility for when you pay back your loan.
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Home equity loans have plenty of drawbacks, too. You need to have a home with sufficient equity before you can even consider this loan type. If your home value decreases after you take out the loan, it may be difficult to sell the home if you need to move for any reason, including relocating for a job.
“Consider the hassle and expense of getting the appraisal with a home equity loan. If you need to borrow a small amount for a brief period, it may not be worth it,” Renfro says. You’ll typically also have to pay several additional fees to take out a home equity loan.
There’s plenty of paperwork to fill out, as well. While personal loans may charge fees and require paperwork, it usually isn’t as big of a deal for a personal loan, which can typically be completed in a day or two.
If you default on your home equity loan, the bank can foreclose on your home, since you put it up as collateral.
While no one plans to miss payments, life doesn’t always go as planned.
Finally, you might end up paying more in interest on a home equity loan despite the lower interest rate. Due to the long repayment term — sometimes up to 30 years — the amount of interest you pay can add up.
“I’d avoid using long-term home equity borrowing for short-term expenses like buying a car. The car could very well need to be replaced before you’ve finished paying for it if you take advantage of the longer terms available with a home equity loan,” Renfro says.
Home Equity Loan vs. Personal Loan: Deciding Which Is Better for You
You must decide whether a personal loan or home equity loan is best for you. In general, shorter-term needs for smaller dollar amounts typically work better with personal loans. Borrowing larger amounts for a longer period usually works best with a home equity loan. Even so, there are plenty of circumstances where you could argue the opposite, as well.
Weigh the pros and cons for your situation and pick the loan that makes the most sense for your needs. Don’t forget, borrowing money isn’t always the answer. Sometimes you need to cut costs or work on increasing your income instead.
Want to learn more about personal loans? Check out our ultimate guide to how personal loans work.
