Personal loan vs. home equity loan: Which is better?

Personal loans and home equity loans can be used for making home improvements, consolidating debt, paying for medical expenses and many other purposes. However, the application process and credit guidelines differ for each option.

Another big difference is that personal loans are unsecured, while home equity loans are secured and use your home as collateral. Consequently, deciding which one is best for your financial situation can be challenging as they both come with significant benefits and drawbacks.

Personal loans vs. home equity loans

Home equity loans and personal loans are both term loans — you repay them over a set amount of time with fixed monthly payments.

Personal loans are typically unsecured, so there is less risk for you if you can’t repay — though defaulting on a personal loan can still lead to serious consequences. Being unsecured also results in higher costs and shorter terms than you will find with most home equity loans.

Personal loans

Personal loans are a type of credit offered by banks and credit unions as well as online lenders. They can be used to cover almost any expense, but common uses include debt consolidation, emergency costs, moving expenses and large purchases.

Loan proceeds are disbursed in a lump sum and are repaid with interest in equal monthly installments. Most repayment periods span one to seven years, but some lenders offer shorter or longer terms.

Borrowers with good to excellent credit are more likely to be approved for a low rate, which lowers the total cost of the loan. Despite that, there are quite a few lenders that work with borrowers with poor credit.

The application process is typically done online and requires basic personal and financial information. You should compare multiple lenders to find the best deal.

Home equity loans

Home equity loans can be larger than personal loans because they use your home’s equity — the value of your home minus what you owe — to determine how much you can borrow. Most lenders will let you borrow up to 85 percent of your home’s combined loan-to-value ratio.

A home equity loan has one big advantage over a personal loan: lower interest rates. But because the loan uses your home as collateral, the lender has built-in recourse if you default on payments — specifically, it can foreclose your home.

Unlike a personal loan, the application process for a home equity loan is a bit more involved. While you can often apply online, the process usually takes a few weeks, since an evaluation of your property must take place. You can look into options from the lender that holds your mortgage and compare other home equity loans to understand how much you can borrow and what you might pay.

When to choose a personal loan

A personal loan may be a better choice in many situations, such as only needing to cover a small expense. They are also a good choice if you don’t want to use your home as collateral.

• You have a smaller expense: While you may be able to find smaller home equity loan amounts at local credit unions, most banks set a minimum of $10,000 or more.
• You don’t want to risk your house: Personal loans are usually unsecured, so you can’t lose your house or any other property if you default.
• You don’t have much equity: If you lack sufficient equity in your home, you may not qualify for a home equity loan at all.
• You have excellent credit: Having excellent credit will qualify you for the lowest personal loan rates, some of which may hover around 7 percent.

When to avoid a personal loan

It’s in your best interest not to choose a personal loan if you need to borrow a sizable amount of money that exceeds the lender’s loan limit. You should also steer clear of personal loans if you can only qualify for steep interest rates that result in an unaffordable monthly payment.

When to choose a home equity loan

On the other hand, taking out a home equity loan instead of a personal loan might make more sense if you need to borrow more than $100,000 or can’t qualify for a favorable rate with a personal loan.

• You have a lot of equity: If you’ve built up a significant amount of equity in your home, you may be able to borrow upward of $500,000 — far more than you would with a personal loan.
• You don’t have the best credit score: Because a home equity loan is a secured loan, it can be easier for people with subpar credit to qualify — just know that you won’t receive the best interest rates.
• You’re looking for low rates: Home equity loan rates are typically lower than personal loan rates, meaning your monthly payment will be smaller and you’ll pay less for borrowing money.
• You want to renovate your home: If you use a home equity loan for renovations, you can deduct the interest paid on your taxes.

When to avoid a home equity loan

Even if you could qualify for a low interest rate on a home equity loan, you should avoid it if you have very little equity in your home. The closing costs and amount you pay in interest could easily outweigh the benefit of taking out a home equity loan in the first place.

Another reason to skip a home equity loan is if money’s tight and you’re living paycheck-to-paycheck. You risk losing your home to foreclosure if you fall behind on the loan payments.

Alternative financing options

Personal loans and home equity loans aren’t the only ways to borrow a large sum of money. If you have different financial needs in mind, try one of these alternatives.

Home equity line of credit (HELOC)

A home equity line of credit (HELOC) works like a credit card. You get a line of credit — typically up to 85 percent of your property’s value — secured by your home, and you can use those funds for almost any purpose. Lenders also look at your credit score, monthly income debt-to-income ratio and credit history to set your HELOC limit.

Most HELOCs have variable interest rates, meaning your rate and monthly payment can fluctuate. Still, HELOCs often have lower interest rates than other types of loans.

You can borrow as much as you need as often as you like throughout the draw period — usually 10 years. You can also replenish your available funds by making payments during the draw period. At the end of the draw period, you will begin the repayment period, which is typically 20 years.

Credit cards

Today’s best credit cards offer a lot of advantages. Making payments on time every month can improve or build your credit rating, and many credit cards offer cash back rewards or frequent-flyer miles that you can redeem on certain airlines. They are as convenient as cash and can be used as a financial safety net for emergencies.

Credit cards do have some downsides, though. They frequently charge high interest rates on cash advances and balance transfers. Missed or late payments can damage your credit, and there is always the chance of credit card fraud on your account. Additionally, some cards have high annual fees from as little as $25 to more than $295 per authorized user.

Personal lines of credit

A personal line of credit is another option that operates similarly to a credit card. You can borrow as needed up to your line’s maximum limit. Taking one out over a credit card may make sense if you can qualify for a lower rate — personal lines of credit generally have lower average rates than credit cards.

However, a significant downside is that, unlike credit cards, personal lines of credit don’t have grace periods. As a result, this means that interest starts to accrue as soon as you borrow against the line of credit. So, if you can qualify for a credit card with a 0% APR promotion, it might make sense to avoid a personal line of credit.

Bottom line

The choice between a personal loan and a home equity loan depends on your financial needs. Both options have advantages and downsides to be considered before applying, but they are suitable if you need to borrow money.

No matter which you choose, take the time to compare all your loan options, interest rates, fees and repayment timelines before submitting an application.