Which is right for you?

Personal loans and home equity loans can be used for making home improvements, consolidating debt, paying for medical expenses and many other purposes.

Personal loans are unsecured and have a relatively simple application process, but you’ll need good or excellent credit to qualify for the best terms. Home equity loans could be easier to qualify for if you have a lower credit score and the rates are lower, but the application process is lengthier and the loan uses 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.

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Differences between personal loans and home equity loans

Home equity loans and personal loans are both term loans — which allow you to repay them over a set term with fixed monthly payments. And since personal loans are typically unsecured, there is less risk for you if you can’t repay. However, it results in a higher cost and shorter term than you will find with most home equity loans.

How personal loans work

Personal loans typically can be used for any purpose the borrower chooses. Among the most common purposes are debt consolidation, covering the costs of large expenses like weddings or vacations or financing a large purchase like a boat. They are offered by banks, credit unions and online lenders. When you borrow, you pay back your loan with interest over a set term, usually two to five years. However, the repayment window can be as short as six months and as long as seven years.

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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.

How home equity loans work

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 may have a claim over your home if you default.

Unlike with 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 get a full idea on what you can borrow and what you might pay.

When to choose a personal loan

A personal loan may be a better choice than a home equity loan in some scenarios:

• 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. Personal loans, on the other hand, may let you take out as little as $500.

• 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 6.5 percent.

Howard Dvorkin, CPA and chairman at Debt.com, says that if you’re looking to pay off credit card debt, a personal loan is a better option. “If someone has multiple credit cards — totaling more than $5,000 — and a credit score that will qualify them for a reasonable interest rate, a personal loan to consolidate debt may be the right option for them,” he says.

When not to choose 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 have bad credit and can only qualify for steep interest rates that result in excessive borrowing costs and make the monthly payment unaffordable.

Pros and cons of personal loans

Before choosing a personal loan, you’ll want to evaluate the pros and cons.

Pros

• Flexibility. Unlike a mortgage, which can only be used to purchase a house, or a car loan, which is restricted to buying a vehicle, the funds from most personal loans can be used as you see fit.

• Fast funding times. Unlike a home equity loan, which could take weeks to be approved, a personal loan could be approved and the funds in your bank account as soon as the next business day.

• No collateral required. Most personal loans are not secured by an asset like your home or car. This means that if, for any reason, you can’t make your payments, you won’t be at risk of losing your assets.

Cons

• High interest rates. Although interest rates for personal loans are typically lower than credit cards, they’re often higher than the interest rates for home equity loans.

• Lower funding amounts. With a personal loan, despite how much money you may need, the maximum amount you can typically borrow is $100,000. With a home equity loan, if you have enough equity in your home, you can often borrow much more than that.

• Shorter term lengths. Unlike a home equity loan, which can have a term length of up to 30 years, the maximum repayment period for a personal loan is seven years. This can lead to a high monthly payment.

When to choose a home equity loan

In some cases, a home equity loan may be the best option available. You may want to consider a home equity loan if:

• 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 your home equity loan funds for renovations, you can deduct the interest paid on your taxes.

When not to choose 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. If not, 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 check-to-check. Otherwise, you risk losing your home to foreclosure if you fall behind on the loan payments.

Pros and cons of home equity loans

As with a personal loan, there are pluses and minuses to taking out a home equity loan.

Pros

• Longer terms. Home equity loans can have repayment terms as long as 20 to 30 years. This can give you a lower monthly payment.

• Lower rates. Home equity loans typically have much lower interest rates than other types of loans like personal loans or car loans. This means it won’t cost as much to borrow the money.

• Potential tax benefits. If you use the funds from your home equity loan to make improvements to your house, you may be able to deduct the interest you’re paying from your federal tax return.

Cons

• Risk of losing your home. Since your house is used as collateral for a home equity loan, if you’re unable to make payments, your lender could foreclose, forcing you to lose your house.

• Risk of owing more than the home is worth. The amount of money you’re allowed to borrow is based on the value of the house at the time you submit your application. If the market drops and your home loses value, you may end up owing more than what the house is worth. If you want to sell your home, this could make it difficult as you may not get enough money in the sale to pay off your loan.

• Equity requirements. Your ability to borrow against your house is limited to the amount of equity you have in it. Most lenders require you to have at least 15 to 20 percent equity in your home. If you’ve only been in your home for a few years, you may not have reached that threshold, which means you would not be eligible for a home equity loan.

Alternative borrowing 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 HELOC works like a credit card. You get a line of credit secured by your home and can use those funds for almost any purpose. HELOCs often have lower interest rates than other types of loans, and the interest may be tax deductible.

As with a home equity loan, you are borrowing against the available equity in your home, which is used as collateral. You can borrow as much as you need as often as you like throughout the draw period — usually 10 years. You can 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.

To qualify for a HELOC, you need equity in your home. As with a home equity loan, you can often borrow up to 85 percent of the value of your home, minus the outstanding balance on your mortgage. When you apply, lenders will look at your credit score, monthly income, debt-to-income ratio and credit history.

Most HELOCs have variable interest rates, meaning your rate can fluctuate over the term of your loan. As interest rates go up, so does your payment. Also, as with credit cards, the chance for overspending is greater than with a fixed-sum loan. Without a certain amount of discipline and budgeting, you may find yourself saddled with large payments during the repayment period.

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. Some credit cards 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 $1,200), you may experience surcharges from merchants when you pay with your credit card and add-on fees can accumulate quickly.

Home improvement loans

The major distinction between home improvement loans versus home equity loans is that home equity loans are secured, and home improvement loans are typically unsecured personal loans.

Due to the unsecured nature of home improvement loans, they typically carry higher interest rates, but they are ideal for borrowers who are planning small or midsize renovations and don’t want to use their property or homes for collateral.

When it comes to home renovations, however, Dvorkin advises sticking to a home equity loan. “This adds value to a home, instead of putting it at risk, and helps consumers build equity in the long run,” he says. Plus, the interest used on home improvement projects may be tax-deductible if you use the loan to buy, build or improve your home.

The bottom line

The choice between a personal loan and a home equity loan depends on your financial needs. Both loan types have advantages and downsides to be considered before applying, but both are suitable options if you need to borrow money. Either way, take the time to compare all your loan options, interest rates, fees and repayment timelines before submitting your application.