You might see the word ‘debt’ and think it’s a bad thing to have. But the truth is, life happens. A sudden emergency room visit or a costly home repair can squeeze your pocketbook. Or you may have lots of credit card debt you’d like to consolidate. We get it – sometimes finances become stressful.
That’s when creating debt smartly can improve your financial situation. Borrowing money at the right time can not only make sense long term, but it can also help you lower your total monthly financial obligations.
So, rather than stressing about a big repair you need now, putting off having an important medical procedure, or juggling a bunch of credit card statements, you could consider two options: a home equity loan or a personal loan.
Read on to learn more about how each type of loan works and the alternatives to home equity loans and personal loans. By the end of this article, you’ll be well on your way to deciding which one is right for your financial situation.
What Is a Home Equity Loan?
If you are a homeowner and your home’s equity (the difference between what you owe and the appraised value of your home) is greater than 15% – 20%, a home equity loan may be right for you.
A home equity loan (or second mortgage) is a secured loan where you borrow money against your home equity. These loans offer lower interest rates compared to personal loans. Your home acts as collateral for the loan, which also means you risk having the lender take your home if you don’t make your payments. In some cases, you can borrow up to 80% – 85% of your home’s available equity and repay it at a fixed interest rate with fixed monthly payments. Repayment terms usually range from 5 – 20 years for home equity loans.
Home equity loans are available at banks, credit unions and online lenders, and you can start the preapproval process online to see if you qualify without harming your credit score.
With home equity loans, you may be able to write the interest off on your taxes. If you use the money to “build, buy or repair” a home that you own at the end of the year, this could help you save money, too.
A home equity loan:
- Involves closing costs and additional expenses such as a home appraisal and fees, usually between 2% – 5% of the total loan amount
- Can take several weeks to complete
- Has a lower interest rate and longer repayment terms (anywhere from 5 – 30 years)
What You Need To Qualify for a Home Equity Loan
Your debt-to-income (DTI) ratio is a calculation lenders use to compare your gross earnings with your financial obligations. You can find your DTI easily online.
Most lenders may approve a borrower with a DTI below 43%, but that doesn’t mean you can’t find a loan if you have a little more debt. This is true especially if your credit score is 700 or higher and your debt-to-income ratio is around 50%. Depending on your overall financial situation, some lenders may make an exception to this rule.
When a home equity loan makes sense
A home equity loan makes sense when you are a homeowner who needs to borrow a significant amount of money, and you want to take advantage of a lower interest rate with a longer repayment term.
A home equity loan is a better choice than a personal loan when you:
- Need to borrow more than $10,000
- Have more than 15% equity in your home
- Want to finance a home improvement project
- Want to consolidate debt or pay for large medical expenses
- Can wait 6 – 8 weeks for cash-out
- Know the real estate market is improving in your area
When a home equity loan doesn’t make sense
Sometimes a home equity loan makes little sense and a personal loan is a better option.
For example, a personal loan makes more sense when you want to pay off credit card debt, pay for college expenses or finance a vacation.
In each of these scenarios, getting a home equity loan is not a good bet. The reason why is risk. When you decide to borrow money, considering the risk involved is essential. A home equity loan is money borrowed against the value of your house – if you default, you could lose your home. That’s why it’s not a good idea to use your home to add debt you could safely cover with a personal loan.
Instead, it makes sense to tap into your home’s equity to pay down existing debt or to invest in home improvement projects. You could also use a home equity loan to buy an investment property if chances of a return on your investment are high.
What Is a Personal Loan?
A personal loan is an unsecured debt you borrow based on your creditworthiness and pay back to the lender. Consumer loans, installment loans, and multipurpose loans are all types of personal loans.
Unlike home equity loans, which are a form of secured debt, a personal loan doesn’t require collateral to be approved, so no appraisals or fees are involved.
Just like a home equity loan, preapplication for a personal loan can start online or over the phone. You can also apply for a personal loan in person at your local bank or a credit union, and you can use the money for whatever you choose.
You may qualify for a personal loan if you have good credit, a consistent work history and increasing income potential.
Personal loans can help you reduce your monthly expenses, especially if you know your financial situation will improve soon. A personal loan could be a smart way to fund a new business, a vacation or college expenses.
Even if you own your home, a personal loan may be a better option than a home equity loan for expenses like these because of its flexibility.
One difference between home equity loans and personal loans is the time it takes from approval to cash-out. A home equity loan can take up to 2 months to complete. But, if you don’t have much time to wait, you can receive your money from a personal loan in as little as 1 business day.
Although there are no fees associated with personal loans, the interest rate can be much higher than for a home equity loan. Also, the repayment terms are shorter (3 – 7 years), so you have less time to pay the money back.
Some lenders will approve you for up to ten times your gross monthly income. So, if you earn $1,500 – $2,000 a month, you may qualify for a personal loan of up to $15,000 – $20,000. If you make more money, your loan amount may be much larger, but most personal loans will not exceed $100,000.
Similar to home equity loans, the lender will review your entire financial situation during the qualification process. This includes:
- Your line of work
- How long you’ve been with your employer
- How much you will make in the future
- Your credit score
- Your repayment history
Your overall financial positioning helps the lender see your creditworthiness. Lenders like to see a credit score above 700. Credit scores above 720 often get the best interest rates. Depending on your overall credit score, interest rates can range from 5.99% – 35.97%.
In some situations, you might be able to get a personal loan with no prior job history. In those cases, you can potentially qualify by showing your last two paychecks from your current employer.
Once you’re approved for either a home equity loan or a personal loan, you can expect to receive your lump sum payment within a short time. Then, you repay the lender in fixed, monthly installments according to your loan’s terms and conditions.
When does a personal loan make sense?
Getting a personal loan makes sense in these scenarios:
- You only need to borrow a few thousand dollars
- You don’t own a home or don’t have much equity in your home yet
- You have a credit score of 700 or higher
- You don’t want to use your house as collateral
Personal loans are helpful when you need money in a hurry. You simply need to apply, be approved and receive your funds. Then you’ll make on-time payments until the loan is paid off.
For example, say you recently graduated from college and started a new job and your car breaks down on the way to work. Since you just started working and may have skimpy savings, a fast, personal loan may be a great way to get your car fixed quickly.
If you can’t pay for that costly repair now, a personal loan can help you get through a tough time by bridging the gap in your current financial situation. As your financial situation improves, you’ll be better able to pay off the loan. Plus, your car will get you to your job and keep your financial health in top shape.
Personal loans can also be helpful if you recently experienced a life change. For example, if you’re a new single parent with an established credit history but don’t own a house, an unsecured personal loan can help you pay costly medical bills. You could even use one to start a new business, especially if you have an idea you’d like to pursue.
Personal loans may be helpful when you don’t have much equity in your home, or have a high debt-to-income (DTI) ratio or lower credit score. And, the best part is that there are no limitations on what you can do with your money once you’ve received it.
What Are the Pros and Cons of Home Equity Loans?
Home equity loans do have pros and cons and times when they make the most sense. If you’re doing a home renovation or costly house repair, or want to consolidate a large amount of debt, using the equity of your existing home may work well for you.
The upside to a home equity loan is that it takes advantage of the equity you’ve acquired in a property you own.
The downside is that if the market takes a downturn, your home value could be less than what you owe on your first and second mortgage.
Another downside is the time it takes from preapproval to cash-out. But, if you can afford to wait for your money, the lower interest rate and longer repayment terms can make a home equity loan a great option.
A home equity loan has other financial advantages that a personal loan does not. We’ve gathered the pros and cons for your quick reference:
✅Longer repayment terms
✅You can borrow more money
✅Your credit score does not factor in as strongly
✅Fixed payment schedule
✅The application process can begin online
⛔Closing costs are often high
⛔Takes a few weeks to get approved
⛔Some lenders have high minimum loan amounts, which may be more than you need
⛔Takes longer to pay off your home
⛔If your home value decreases, you may have combined mortgages greater than its value
⛔Limitations on what you can use the money for
What Are the Pros and Cons of Personal Loans?
Personal loans are fast – you can get your funds in as little as a day after the loan is approved. A personal loan also gives you greater flexibility in how you can spend your money.
You pay what you owe in a shorter amount of time, and there are no fees involved, so you pay less interest overall. As with all things, there can be drawbacks to personal loans, including higher interest rates and the maximum amount you can borrow.
Here’s your quick reference list of the pros and cons of personal loans:
✅No risk of foreclosure
✅Considers your overall financial situation
✅Shorter repayment periods
✅No foreclosure risk on a property you own
✅A fixed payment schedule
✅If you have excellent credit, you can get the best interest rates
✅If your credit is new or lower than average, you may still qualify
✅Application process can begin online
⛔Generally higher interest rates than home equity loans
⛔Could be hard to qualify if you have poor or fair credit
⛔Repayment terms are shorter than home equity loans, which means monthly payments may be higher
⛔Might not be able to borrow as much for very large projects (like home additions)
What Are the Alternatives to Home Equity and Personal Loans?
Home equity loans and personal loans are just scratching the surface on the types of ways you can borrow money from a bank, credit union or other financial institution.
If you have a home with enough equity, you can ask about secured loans that use your home as collateral.
- Home equity line of credit (HELOC): A HELOC requires equity in your home and works as a second mortgage, but functions like a credit card. It’s an open line of credit with a time period where you can borrow money and repay interest only or the entire amount. The interest rate will be lower than a credit card and may be tax deductible.
- Cash-out refinance: A cash-out refinance is a refinance of your home loan that allows you to take some of the equity you’ve built into your home. You continue to make monthly payments according to your interest rate and repayment terms.
If you don’t want to risk using your home as collateral, you can look into accessing unsecured loans that let you borrow based on your ability to repay the loan.
You can use the loan to consolidate personal loans and secured loans to make a home repair or to pay a sudden large expense.
- Credit cards: Credit cards are a form of unsecured credit that doesn’t require collateral. You will have a fixed interest rate and make monthly payments immediately after borrowing the money until the balance is paid off. If you’re making a large purchase you may want to find a credit card with a low or 0% interest rate. Some credit cards will also let you pay off larger purchases in installments. Your monthly payment is added to your monthly minimum payment, but once you’ve made all the payments, you’re done.
- Personal line of credit: A personal line of credit is a type of personal loan with a variable interest rate that allows you to withdraw money by check or money transfer. You use what you need and repay only the amount you’ve borrowed. This differs from a personal loan in that you borrow only what you need as you need it and do not receive a lump sum payout.
- Payday advance loans: A payday advance loan is a high-interest personal loan that allows you to borrow money against your future earnings. You write a postdated check for the amount borrowed, including interest to repay the loan on a predetermined date. This should be a loan of last resort because the interest rates are exceptionally high. It’s best to steer clear of payday loans.
Choose What’s Right for You
Home equity loans and personal loans are a matter of choice and circumstances. Each gives you a certain level of flexibility when you need to borrow money to help pay for a big expense.
Home equity loans can provide tax advantages. But, when you need your money fast and want flexibility, a personal loan might be right for you. Do yourself a favor and shop around to compare interest rates and repayment terms before you commit. It’s important to know how much you need and why. You’ll also want to be careful about your financial actions, as lenders do the underwriting.