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Home equity loans are second mortgages, backed by the value of your home, that allow you to cash out on a portion of your ownership. By contrast, personal loans are also installment loans but are unsecured, which means they are not backed by the rights to any property. We compare the pros and cons of home equity loans versus personal loans to help you determine which might be the best financing option for you.
Home Equity Loans Vs. Personal Loans: Side-by-Side Comparison
Home equity loans allow homeowners to take out loans secured by your ownership in your home. Close-end home equity loan proceeds are disbursed in a single lump sum and repaid with fixed monthly installment payments, like a traditional mortgage. Interest rates on home equity loans are typically fixed, and terms usually vary from 5 to 20 years.
Personal loans, also known as signature loans, are general-purpose installment loans that are not secured by collateral. The interest rates on these loans are usually fixed, and loan terms range from 1 to 7 years, with the most common being 3 to 5 years.
Home Equity Loan vs. Personal Loan
|Home Equity Loan||Personal Loan|
|Rates||~3% to ~11%||~3% to ~36%|
|Loan Fees||2%-5% of the initial loan amount||1%-8% of the initial loan amount|
|Collateral||Lien against home||None|
|Loan Term||~5 to ~20 years||~1 to ~7 years|
|Payments||Amortizing principal and interest payments||Amortizing principal and interest payments|
Pros and Cons of Home Equity Loans and Personal Loans
Home equity loans are the better option for larger loan amounts and longer repayment periods. A personal loan would be a better option if you don’t hold equity in real estate or if you need access to funds quickly. Some of the most common scenarios where people consider financing are listed below; we review whether you’re better served by a home equity loan or a personal loan in each situation:
This depends on how much debt you need to consolidate as well as how high the interest expense is on your outstanding debt.
If the amount needed is greater than $50,000, a home equity loan may be the better option due to the lower interest rates and higher permitted loan amounts. Personal loans are most readily available in amounts lower than $50,000, but they don’t force you to place your home on the line and sometimes have lower closing costs.
If the goal is to reduce your monthly payments and improve your cash flow, a home equity loan will likely offer a longer repayment period (and therefore lower monthly payments). Most personal loans are offered in shorter terms, so your monthly payments may be higher. This could be advantageous if your goal is to pay off multiple high interest credit cards quickly.
Home equity loans are well suited to financing home renovations due to their low interest rates and tax-advantaged status. The IRS usually permits the deduction of mortgage interest paid on home equity loans for eligible renovation expenses.
By contrast, the interest paid on personal loans is not tax deductible and generally costs more; personal loans should therefore be a backup option when you don’t own sufficient equity in your home.
If you’re financing higher education expenses, then home equity loans generally offer lower monthly payments for cash-strapped students and parents. Personal loans generally have higher monthly payments and interest rates due to their shorter repayment periods. This is especially important for students trying to stretch their dollar in the short run.
Parent and student borrowers alike should be aware that neither home equity loans nor personal loans qualify for tax deductions under the IRS tax code, as of 2018. Relative to both home equity and personal loans, public and private student loans are likely better suited for funding education needs due to their tax deductibility and payment deferral features.
Personal loans are quicker to underwrite and approve because there’s no need to appraise any underlying property. This makes them a better option when you need money in a pinch. They also allow you to spread out payments over longer periods without tying up equity in your home. This makes personal loans a better option if you anticipate difficulty making payments and don’t want to risk foreclosure.
Keep in mind that personal loans are likely to warrant higher interest rates, and therefore will cost more over the long run; it may make sense to consider debt refinancing with a cheaper home equity loan if you can afford and intend to repay them over long periods of time.
Weddings, Vacations and Large One-Time Costs
If you’re financing a large, one-time expense, like a wedding or dream vacation, then a personal loan is likely the better option. As a general purpose loan, there are few (if any) restrictions on what the funds can be used for. There’s also a smaller likelihood of you having to continue making payments over decades, due to their shorter terms.
We strongly recommend that borrowers refrain from using debt to fund extravagant one-time expenses; however, if you must, a personal loan is the better choice as it won’t risk foreclosure on your home.
Key Factors to Consider for Home Equity Loans and Personal Loans
Aside from the obvious rate and term differences, the three major traits that borrowers should consider when comparing home equity loans and personal loans are: 1) tax status, 2) required collateral and 3) credit qualification. These factor in other risks that aren’t obvious at the onset of your loan.
Tax deductibility introduces another cost dimension to consider when comparing home equity loans and personal loans. As of 2018, the IRS still permits mortgage interest to be deducted on home equity loans, as long as the funds are used to pay for eligible home renovations. By contrast, under no circumstances is interest paid on personal loans deductible. This plays a major role if you intend to use your home equity loan to fund home improvement costs.
Collateral and consequences of default
The stakes are higher for home equity loans when it comes to loan default, since they are secured by your interest in your home. Failure to make timely payments on your home equity loan could result in foreclosure. In addition to the short-term implication of leaving you homeless, this would have a disastrous long-term impact on your credit.
Personal loans are not secured by any collateral, so defaulting on a personal loan won’t necessarily result in the loss of your property. Keep in mind that not paying your personal loan will still have a major negative impact on your credit score, particularly if you enter bankruptcy.
Credit criteria are stricter on home equity loans than on personal loans. Most home equity lenders require a minimum credit score of 620; although much higher scores are required for the most competitive rates. Personal loan lenders offer a range of rates, but they are generally attainable even if your credit scores and history are poor. You’ll end up paying a much higher interest rate on unsecured personal loans with lower credit scores, all else held equal (all the way up to 36% in some states—the maximum allowable by law).
While there are no overarching guidelines for home equity lenders when it comes to evaluating your loan application, they tend to stick to mortgage industry standards—verifying your employment and income. Personal loan guidelines are generally looser, with some only requiring stated employment and income without follow-up verification.