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Home equity loan vs personal loan: Make the smart choice

Peter Warden
The Mortgage Reports editor

In this article:

When choosing a solution to a cash-flow problem both home equity and personal loans can do the job. But your circumstances will determine which works better in your situation.

  1. Home equity loans and lines of credit (HELOCs) have lower rates but require home equity
  2. Personal loans are usually faster to get, have lower set-up costs and shorter terms
  3. Personal loans are unsecured, and most require excellent credit

In general, personal loans are great for smaller amounts that you repay quickly. Home equity loan terms can be extended for many years. Of course, you pay more interest in total when your payoff is extended.

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Consider all options

Don’t ignore other contenders in the battle of the loans. For example, a balance transfer credit card could produce the breather you need for smaller sums. Or a peer-to-peer loan might meet a need of up to, say, $40,000. And a home equity line of credit (HELOC) offers different advantages and disadvantages from its home equity loan sibling.

Related: Home equity loan vs line of credit (HELOC)

You need to compare as many options as you can find.

What are home equity loans and personal loans?

Both of these are installment loans. In other words, you borrow a fixed amount of money for a fixed period of time and make fixed or variable payments each month.

The main difference is that personal loans, also called signature loans or unsecured loans, are not backed by your home. The personal loan lender cannot foreclose on your home. But a mortgage lender can. For this reason, loans secured by your house have lower interest rates — the lender has more protection.

Related: How does a home equity loan work?

Personal loans can have fixed or variable interest rates. When rates are variable, if the Federal Reserve increases general rates, your payments are likely to rise in line with its changes. Home equity loans can also be fixed or adjustable. Most home equity loans have fixed rates. Most home equity lines of credit have variable rates.

Whichever you choose, you should look out for prepayment penalties, which some —but far from all — lenders impose. These kick in if you want to clear your loan early. Of course, they don’t matter if you’re sure you’ll want the loan to run its full term. But you should check your loan agreement for them and only proceed if you’re comfortable with their potential costs.

Some key differences

When choosing which of these loans suits you better, it’s the differences rather than the similarities that are important. The following are some key ones.

Term, size and rates

You may find exceptions, but personal loans usually last between one and five years. HELs can have terms of five to 30 years.

Personal loans also tend to come with higher interest rates than HELs. At the time of writing, one national lender is quoting rates for the former in a 7.24 percent to 24.24 percent range. Depending on prevailing rates when you apply, and your personal circumstances, you might get a HEL for around 5 percent. However, you’d need to be an attractive borrower to qualify for that rate.

You don’t need to be a math genius to work out that a shorter term and higher rate are going to make a personal loan’s monthly payments much higher than those for a HEL. That’s why few borrow more than $100,000 using a personal loan.

On the other hand, stretching out your repayment to 30 years instead of, say, five years will almost certainly cause you to pay more total interest, even if the interest rate is significantly lower.

Secured vs unsecured

Home equity loans are “secured.” You’re putting up your home as security. So, if you fail to keep up your end of the bargain, your lender can quite quickly seize your home through foreclosure. This happens most often when a borrower can’t keep up monthly payments.

Personal loans (sometimes called signature loans) are “unsecured,” which means you’re not putting up a particular asset as collateral. Of course, lenders will still come after you in court if you fail to keep up payments. And, ultimately, they might even be able to bankrupt you. But they don’t have a direct legal route to seize your home if you get into trouble.

This is an important point. Nobody should put their home on the line lightly.

Time and costs for setting up loan

A HEL is a second mortgage. And it comes with virtually all the time-consuming administrative baggage you encountered when you set up your first mortgage. It also comes with similarly high closing costs, including fees for appraisal, title search and preparing documents.

Some lenders offer HELs with no closing costs. However, it may be that those costs are merely hidden by a higher interest rate. Of those that do charge them, most will let you roll them up in your new loan. Either way, you need to keep an eye on your total cost of borrowing when you compare deals.

Home equity lines of credit usually come with low or even no set-up costs. But their interest rates are variable and there are often prepayment penalties.

Personal loans are typically much faster and cheaper than HELs to set up. Indeed, some lenders charge no origination fees at all. Those that do typically charge a small fraction of what you’d pay in closing costs on a HEL. It’s possible to get a personal loan approved in a week or even days, though really big sums may take longer.

Home equity loan vs personal loan: qualifying for each

For both these loans, lenders are going to want to make sure you’re creditworthy and can comfortably afford the payments. If you’re borrowing a significant amount, they’ll expect your credit score to be in the good-excellent range. And they’ll want you to prove you can easily cover the costs in your household budget.

And they’re likely to be stricter over the credit scores and household finances of applicants for personal loans. That’s because they don’t have the comfort of knowing they can quickly foreclose on a home if things go wrong.

Lenders may be nervous if a large proportion of your income is going to service other debts, including your existing mortgage, is high. You may be able to allay their fears if you use some or all of your new borrowing to pay other debts. If so, those creditors will likely be paid directly by the title company a closing.

Home equity loans: another hurdle

The “equity” in “home equity loan” refers to the equity you have in your property. That’s the sum by which the current market value of your home exceeds your present mortgage balance. For example:

  • Current market value of your home: $200,000
  • Amount you owe on your mortgage (its balance) today: $120,000
  • Your equity: $80,000

Unfortunately, that doesn’t mean you’re going to be able to borrow all that $80,000. Lenders will want you to keep some equity in your home. Many insist your total borrowing doesn’t exceed 80 percent of your home’s value, though some may stretch that to 90 percent or so. In the industry’s jargon, you need a loan-to-value (LTV) ratio of 80 percent or 90 percent.

LTV example

Let’s carry on with that same example:

  • Current market value of your home: $200,000
  • Eighty-percent LTV: $160,000
  • Less your current mortgage balance: $120,000
  • Amount available for home equity loan borrowing: $40,000

If you find a lender willing to go with a 90 percent LTV, you’ll be able to borrow $60,000. That 90 percent LTV would cap your borrowing at $180,000 (90 percent of $200,000) and you have to deduct from that your existing mortgage of $120,000.

All other things being equal, the lower your LTV, the lower your interest rate will be.

Home equity loan vs personal loan: 3 questions

When you’re picking your winner in the home equity loan vs personal loan contest, three questions are likely to guide you to a better choice.

1. How much do I need to borrow?

The bigger your loan, the more likely you are to need a HEL’s lower monthly payments. However, you may be constrained by the amount of equity you have in your home.

Meanwhile, a HEL rarely makes sense for smaller sums, simply because it costs so much to set one up.

2. What is the cost of each option?

You need to work out the total cost of borrowing for every deal you consider. That applies to all the personal loan and HEL offers you receive. And you always get at least three quotes for all your borrowing. Don’t you?

You need to know how much your borrowing will have cost you in interest and set-up charges (origination fees or closing costs, if any) when you finally make your last payment. It’s critical you know that dollar sum.

Of course, you don’t have to go with the lowest cost. There may be good reasons why you choose the lower monthly payments of a HEL over a cheaper personal loan. Which leads on to …

3. What payment can I afford?

If you can afford the higher monthly payments of a personal loan, you’ll almost certainly be better off, in the long run, choosing that route. Even though you’ll likely be paying a higher rate and making bigger payments, you’ll be borrowing for a significantly shorter period. And that makes a bigger difference to your total cost of borrowing than interest rates in all but the most exceptional circumstances.

Typically, a personal loan also has the advantage of being over faster. You’ll be free of the burden sooner. That’s especially important if you’re using your loan to consolidate existing debts, such as credit card balances. Do you really want to be paying for the shoes you bought last month and the restaurant bill you charged last week in 15 years’ time?

But, more importantly, you must be sure you can comfortably cover your payments whichever type of loan you choose. Stretching your budget too far can lead to stress levels — and ultimately dire consequences — that just aren’t worth the savings you stand to make by making the supposedly “smart” choice.

Verify your new rate (Dec 11th, 2019)