A home equity loan is a secured loan, using your home as collateral, while a personal loan is unsecured, meaning you don’t put up any collateral. Beyond this key difference, these borrowing options are similar in that both are typically lump-sum, fixed-rate loans that you’ll repay over a specific length of time.
If you’re wondering which is the better choice for your current financial needs, it can be wise to take a closer look at how each one works and the pros and cons involved.
What Is a Home Equity Loan?
Sometimes referred to as a second mortgage, a home equity loan allows you to use your home as collateral when you need to borrow money. Here are a few key points to note:
• With this type of loan, the amount you can borrow is based on the equity you have in your home. Your home equity is the difference between your home’s current value and what you currently owe on your mortgage. Lenders may require that you have a minimum amount of equity (typically, at least 15% to 20%) to qualify.
• If you’re a new homeowner, you may not have built up enough equity to qualify for this type of loan. But if you made a substantial down payment, you’ve owned your home for a while, or your home’s value has increased substantially since you purchased it, a home equity loan could be an option worth considering.
• Lenders typically offer more competitive terms for this type of secured loan because it’s a lower risk for them. To put it another way: If the borrower defaults, they can foreclose on the property and recover the amount they’re owed.
Recommended: Understanding Home Equity
How Does a Home Equity Loan Work?
Home equity loan funds are generally distributed in a lump sum with fixed-rate monthly payments, though variable-rate options are offered by some lenders. Repayment periods can vary from five to 30 years. Here’s a closer look at how they work:
• When you apply, you can expect lenders to look at your personal creditworthiness, including your debt-to-income ratio (DTI) and credit score. In most cases, you will need a credit score of 680 or higher to unlock favorable terms. A higher three-digit score may help you get approved for a better rate.
• Your lender will likely require a home appraisal to verify your home’s value. (This is one of the reasons why snagging a home equity loan can be a more time-consuming process than getting an unsecured loan.)
• If you’re eligible, you may be able to borrow up to 80% or, in some cases, even 90% of your home’s equity. So, for example, if you have $150,000 in equity, you might qualify to borrow $120,000 to $135,000.
It’s important to note that a home equity loan is not the same thing as a home equity line of credit (HELOC). A HELOC is a type of revolving credit (you draw against your limit over time), while a home equity loan is an installment loan, paid out in a lump sum.
What Is a Personal Loan?
A personal loan is similar to a home equity loan in that it allows you to borrow a lump sum of money, and you’ll repay those funds — with interest — in regular installments over a set period of years.
To understand what defines a personal loan and distinguishes it from a home equity loan, consider these points:
• Most personal loans are unsecured, which means you don’t have to use your home or any other asset as collateral to borrow the money.
• Because the lender is taking more risk with this kind of loan than a home equity loan, interest rates may be higher.
• Since you don’t need to have a home appraisal and other steps completed, you may find that securing a personal loan vs. a home equity loan is a significantly quicker process.
How Does a Personal Loan Work?
If you decide to go with a personal loan, you’ll likely have a number of options to choose from — they’re offered by many banks, credit unions, and other lenders. And because lenders’ terms can vary significantly, you may want to do some comparison shopping before you make a choice.
When applying, it’s wise to be aware of these points:
• If you aren’t using an asset to secure your personal loan, you can expect lenders to put a high priority on your credit score, income, and DTI when you apply. The higher your credit score, the better in terms of getting approved and securing a favorable rate. Many lenders look for a FICO® score of at least 580, but applicants who have scores over 700 are likely offered the most favorable terms. (Personal loan rates are usually lower than credit card rates, however, even if the loan is unsecured.)
• Pay attention to how the length of the loan affects your payments. Personal loans are typically repaid over a term of two to seven years. If you’re looking for smaller monthly payments, a longer term may suit your needs, but that may increase the overall cost of the loan. A personal loan calculator can help you compare your monthly payments and the total (principal plus interest and fees) to be repaid.
Comparing Home Equity Loans and Personal Loans
Both home equity loans and personal loans usually offer fixed-rate, lump-sum financing options with terms that can be tailored to fit the borrower’s needs. And both offer borrowers a certain amount of flexibility in how the money can be used.
But there are some questions you may want to consider when deciding between the two, including:
How Much Do You Plan to Borrow?
If you need to borrow a large amount and you’re looking for a lower interest rate, you may find a home equity loan is the right product for your needs. Your monthly payments may be smaller if you sign up for a longer repayment period.
If you need a smaller loan — a few thousand dollars, for example, or even just a few hundred — a personal loan may be the more practical choice. But even if you plan to borrow a large amount, you may choose a personal loan to avoid tying your home to your loan. Some lenders offer large personal loans — as much as $100,000 or more — to well-qualified borrowers.
What’s the Timeline?
One of the major drawbacks to a home equity loan is that the approval process can take weeks (say, two to six weeks). Lenders typically will require an appraisal to determine your home’s current value, and there’s usually more paperwork involved with this type of loan.
A personal loan application, on the other hand, can take just minutes to complete online, and some lenders offer same-day approvals. If you’re approved, it may take only two or three days until the money lands in your checking account.
What’s the Risk?
Home equity loans come with more risk for the borrower than a personal loan. If you default on your payments and the lender decides to foreclose, you could potentially lose your home. Also, if you decide to sell your property, you’ll have to pay back the home equity loan.
Personal loans also carry some risk for borrowers. If you default on a secured personal loan, the lender could take whatever asset (a car or bank account, for instance) you used for collateral. And whether your loan is secured or unsecured, late or missed payments could lower your credit score (this can be true for home equity loans as well). If the account goes to collections, you could be sued for what you owe.
How Do You Plan to Use the Money?
You can use funds from both types of loans for just about any (legal) purpose. Borrowers often use them to:
• Consolidate debt (say, to pay off high-interest credit card debt)
• Pay for wedding or vacation costs
• Make home improvements
• Pay off medical or dental bills
• Finance car repairs or the purchase of a vehicle
• Fund moving expenses
There may be benefits to one or the other loan type that makes it a better fit for your specific plans. For instance, with a home equity loan, you can deduct the interest on funds you used to “buy, build, or substantially improve” the home you used to secure the loan, according to the IRS. So if you’re hoping to make home renovations, one of the different types of home equity loans may be the right choice.
You typically can’t deduct the interest on a personal loan. But the ease and speed of getting a personal loan may make it the better pick if an unexpected expense comes up — say, if your refrigerator or air conditioning system goes out, and you need money quickly for a replacement or major repair.
Pros and Cons of Home Equity Loans vs Personal Loans
Here’s a look at some of the advantages and downsides of a personal loan vs. home equity loan:
Personal Loan Pros
• Flexible borrowing amounts and terms
• Often unsecured, meaning there’s no risk of losing your home
• Convenient and fast access to funds
Personal Loan Cons
• Interest rate may be higher if loan is unsecured
• Depending on borrower’s creditworthiness, may require collateral
• Lenders may charge a loan origination fee, late payment fees, and/or a prepayment penalty
Home Equity Loan Pros
• Flexible borrowing amounts and terms
• Interest rate may be lower than unsecured loans
• Interest may be tax-deductible if used for home improvements
Home Equity Cons
• If you default on the loan, the lender could foreclose on your home
• Approval process can take longer (two to six weeks) and may include additional costs
• Some home equity loans have prepayment penalties and/or other fees
• Must have enough equity in your home to qualify for the amount you want
• If you sell your home, you’ll have to repay the loan
Carefully considering the upsides and downsides of a personal loan vs. a home equity loan is an important step in making the financial decision that suits you best.
The Takeaway
Home equity loans and personal loans both typically offer lump-sum payments at a fixed rate for a specified term. Home equity loans use your property as collateral, while personal loans are often unsecured.
It’s important to look at how each one might sync up with your particular financial situation and your reasons for borrowing the money. If you’re a homeowner, tapping into your home equity might get you a lower interest rate and a possible tax break. But the loan process is typically quicker and easier for a personal loan — and you won’t have to tie the loan to your home and put your residence at risk.
If you think a personal loan might be right for you, see what SoFi offers.
Think twice before turning to high-interest credit cards. Consider a SoFi personal loan instead. SoFi offers competitive fixed rates and same-day funding. Checking your rate takes just a minute.
FAQ
Can personal loans be used to consolidate debt?
Yes, debt consolidation is one of the top reasons borrowers choose to get a personal loan. You might use this kind of loan to pay off one or more high-interest loans or credit card accounts, potentially simplifying repayment and lowering your costs.
What credit score is needed for each loan type?
Here are how credit scores for home equity loans vs. personal loans typically stack up: Lenders typically like to see a credit score of 680 or higher for home equity loans and 580 or higher for personal loans. Borrowers with higher credit scores usually qualify for more favorable loan rates.
What is the downside of a home equity loan?
The biggest drawback to a home equity loan vs. a personal loan is that it’s tied to the home you use to secure the loan. This means that if you default on your payments, the lender could foreclose on your home. Also, if you decide to sell your home, you’ll have to pay back your home equity loan as well as your mortgage.
Photo credit: iStock/milorad kravic
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