When it comes to financing significant expenses or consolidating debt, two popular options are home equity loans and personal loans. Both types of loans can provide the funds you need, but understanding their differences is crucial to making an informed decision. Before deciding which loan product is right for you, you’ll need to examine key differentiating factors such as the need for collateral, borrowing amounts, repayment terms, interest rates and credit score requirements.
What is the difference between a home equity loan and a personal loan?
While a home equity and a personal loan both provide access to funds, they are two significantly different lending products.
Secured vs. unsecured loans
Home equity loans are secured loans, meaning they are backed by collateral. In this case the collateral is your house. Secured loans are directly tied to specific assets, ensuring the lender can recover their investment in case you default on the loan.
Personal loans are typically unsecured, meaning they don't require any collateral. As a result they are accessible to a broader range of borrowers. However, it also means personal loan interest rates may be higher than home equity loans as the lack of collateral means the lender is taking a bigger risk.
Home equity loans allow you to leverage the equity accumulated in your home for borrowing purposes. The equity you have is the appraised value of your home minus any outstanding mortgage balance. A home equity loan generally allows you to borrow a maximum of 85% of the equity in your home.
On the other hand, various factors determine the borrowing amount for personal loans, such as your income and credit history, the purpose of the loan, the lender's policies, etc. The maximum amount you can borrow with a personal loan is generally $100,000. It's wise to explore various lenders and utilize a personal loan calculator to find the terms that best suit your financial needs.
Home equity loans often come with longer repayment terms, typically 5 to 30 years. This allows borrowers to spread the repayment over an extended period. Personal loans usually have shorter repayment terms, typically ranging from one to seven years, which generally means higher monthly payments.
Average interest rates
Home equity loans tend to have lower interest rates than small personal loans due to the collateral involved. The best home equity loan rates are usually fixed, providing stability throughout the loan term.
Personal loan rates, being unsecured, are generally higher since there's no collateral to mitigate the lender's risk. Most personal loans come with fixed rates between 6% and 36%.
Credit score requirements
Although home equity loans are secured by collateral, they still typically have more stringent credit score requirements since they involve larger borrowing amounts. Lenders often prefer borrowers with good to excellent credit scores.
Personal loans may be more accessible to borrowers with only fair to good credit. Lenders offer personal loans to a broader range of credit profiles but interest rates and terms will vary based on creditworthiness. If you have a low credit score, there are personal loans for bad credit available from certain lenders. Have a look at our picks for the best bad credit loans.
How to get approved for a personal loan
Improving your credit score is the best way to increase your chances of getting a personal loan. You are allowed to request a copy of your credit report from each of the major credit bureaus (Equifax, Experian and TransUnion) annually. Review it and report any errors or discrepancies to the credit bureau and creditor. If you can get incorrect negative information removed, your credit score will likely improve.
For personal loans, lenders typically have a minimum credit score requirement of around 660. They may also set an annual income threshold. Certain lenders will consider other factors, including income and rental history, rather than relying on your credit score to determine eligibility.
Next, assess your debt-to-income (DTI) ratio, which compares your monthly debt payments to your income. Lowering your debt and increasing your income can positively impact your chances of approval with lenders as well.
Prepare required documents such as proof of income, identification and bank statements to expedite the loan application process.
Upon approval, the lender can transfer the loan funds as a lump sum into your bank account, usually within a few days. If you are specifically using the funds to pay off a creditor or consolidate debts, the lender may also transfer the funds directly to the entities you owe.
Repayment begins as soon as the loan is disbursed. Lenders calculate interest based on the entire loan amount, regardless of whether you utilize the whole sum or only a portion. Some lenders may assess origination fees and prepayment fees for personal loans.
When to get a personal loan
There are several situations where a personal loan may make sense:
- Debt consolidation: If you have multiple high-interest debts, consolidating them into a single personal loan with a lower interest rate can simplify your finances and save you money as you work to pay off the debt.
- Unexpected medical expenses: A personal loan can help you cover these substantial expenses while providing a structured repayment plan.
- Home improvements: If you want to renovate your home or make necessary repairs, a personal loan can provide the funds needed for the project.
- Wedding or special event financing: Personal loans can cover the costs of significant life events such as weddings.
- Education expenses: A personal loan can help cover tuition fees and related educational expenses if you or a family member are pursuing higher education.
How to get approved for a home equity loan
Most lenders have a minimum home equity requirement of 15% to 20% and a minimum credit score of 620 to get a home equity loan. You can calculate your home equity by subtracting your outstanding mortgage balance from the current appraised value of your home. To get your home equity percentage, divide this number by the current value of the home and multiply by 100.
Lenders also use the loan-to-value (LTV) ratio to determine the amount you can borrow against your home equity. A lower LTV ratio, typically below 80%, can increase your chances of approval.
As with personal loans, a good credit score enhances your chances of approval for a home equity loan. Review your credit report, dispute any inaccuracies and take steps to improve your credit score if necessary. When you are ready, you can initiate the process by contacting your selected lender or consulting with a loan broker. Also, don’t forget to ask about home equity loan tax deductions.
During the closing stage, it's customary to pay fees and closing costs which typically range between 2% and 5% of the total loan amount. Repayment terms for these loans usually span from five to 30 years.
Once approved, your lender disburses the loan amount to you as a lump sum, charging interest on the entire loan balance. It's essential to recognize that since your home is collateral for the loan, the lender has the authority to initiate foreclosure proceedings in case of missed or late payments.
When to get a home equity loan
Home equity loans can be beneficial for various purposes, and you may want to get a home equity loan for any of the following reasons.
- Major home renovations: If you're planning significant renovations or additions to your home, a home equity loan can provide the necessary funds to complete the project.
- Consolidating high-interest debt: A home equity loan can help you pay off the debt at a lower interest rate if you have substantial credit card debt.
- Funding education expenses: Home equity loans can cover education expenses, particularly for post-secondary education or advanced degrees.
- Starting a business: If you want to start or expand a business, a home equity loan can provide the capital you need to finance your venture.
- Long-term financial planning: Some individuals use home equity loans as part of their retirement planning strategy or to invest in other long-term assets.
Home equity loan vs. personal loan FAQs
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Summary of Money's home equity loan vs. personal loan
Choosing between personal and home equity loans depends on factors such as your borrowing needs, financial situation and long-term goals. Though not covered here, you can also consider a home equity line of credit (HELOC) instead of a personal loan. Home equity loans offer larger borrowing amounts, potentially lower interest rates and longer repayment terms, but require collateral. Unsecured personal loans are more accessible to individuals with diverse credit profiles, offering flexibility and faster approval times.
Remember to consider your repayment capacity, creditworthiness and the purpose of your loan before finalizing your choice. Ultimately, a personal or home equity loan can be a valuable financial tool, providing you with the means to achieve your goals and manage your expenses effectively.