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If you need money, you have a couple of options, including a personal loan or a home equity loan. Both options have advantages and disadvantages, and here’s everything you must know to decide.
Personal Loans vs. Home Equity Loans: The Differences that Matter
Personal loans and home equity loans may seem similar, but they have some major differences you should understand.
Home equity loans have lower interest rates than personal loans for one reason – collateral. You must put your home up as collateral or ahome equity loan, but personal loans are unsecured (have no collateral).
If you stop making your home equity payments, the lender can start foreclosure proceedings. But if you stop making your personal loan payments, the lender has nothing to repossess. To make up for this risk, lenders charge higher interest rates on personal loans.
Home equity loans usually have much longer terms than personal loans. Depending on the lender, you can take out a home equity loan for 15 to 30 years. On the other hand, personal loans are shorter term, usually lasting no more than 3 – 5 years.
Personal loans are for smaller financial needs, and some personal loans start as low as $1,000. On the other hand, home equity loans usually have much higher minimum loan amounts, starting at around $10,000 or more.
Eligibility and Requirements
Eligibility and requirements are where you’ll see the largest differences between a personal loan and a home equity loan.
For both, you need decent credit, but because home equity loans have collateral, you can get by with a lower credit score than you would with a personal loan. Because personal loans are unsecured, banks reserve them for high credit borrowers less likely to default.
Another major difference is the need for home equity for a home equity loan. Personal loans don’t have collateral, so you don’t have to worry about equity in anything. To take out a home equity loan, though, you’ll need more than 20% equity in your home. Most loan programs require you to leave 20% of the equity untouched. It can take time to build equity, so not everyone may be eligible for it.
Home equity loans also focus on your debt-to-income ratio. This compares your monthly debts to your gross monthly income (income before taxes). Ideally, you shouldn’t have a DTI higher than 43% to get approved for a home equity loan. Personal loans don’t focus on your DTI much, but instead, make sure you have verifiable income.
Funding times are where personal loans shine. If you are in a hurry for the funds, a personal loan is your best bet. Depending on the lender, you can sometimes get your funds as soon as the same day or within 7 days.
Home equity loans, on the other hand, take much longer. Lenders need to do much more underwriting, including an appraisal and securing the title search to determine if the home is worth enough and doesn’t have any liens on it. Home equity loans can take up to a month to fund.
>> More: Best Personal Loans
Pros and Cons of Personal Loans
- You don’t risk any collateral if you can’t make your payments (it still hurts your credit, but you don’t lose your home)
- Anyone can qualify even if you don’t own a home
- They fund fast, sometimes as soon as the same business day
- The approval process is fast
- You can borrow small amounts
- Interest rates are often higher than home equity loans
- There are lower loan limits than home equity loans
- You often need great credit to qualify
Pros and Cons of Home Equity Loans
- You can get a much longer repayment term
- You can borrow much more (if you have the equity)
- You don’t need perfect credit
- Interest rates are usually much lower
- If you use the funds to reinvest in your home, you may deduct the interest charges
- You must have equity in your home to qualify
- Underwriting and funding could take several weeks
- You put your home at risk if you default on the loan
When Should You Use a Personal Loan Instead of Home Equity Loans?
It can feel like a tough decision to choose between a personal loan and a home equity loan, but here’s a quick cheat sheet.
Do you want to risk your house?
If you aren’t 100% certain about your ability to make the payments on time moving forward, risking your home is often not worth it. While you should never take a loan you can’t afford, putting your home at risk isn’t advisable if you’re unsure of your ability to make the payments.
Do you only need to borrow a small amount?
A personal loan is usually better for small loan amounts. Home equity loans take a long time and incur a lot of fees just to get the small amount you need. On the other hand, personal loans fund fast and have very few fees, making more sense when you only need a small amount.
Do you have equity in your home?
If you don’t have over 20% equity in your home, a home equity loan isn’t an option. A home equity loan is a second loan on your property, so lenders want to know there is enough equity in the home to pay the first lienholder (your first mortgage lender) and the lender giving you the home equity loan.
Do you have great credit?
Because personal loans are unsecured, lenders like borrowers with great credit scores. If you have great credit, you’ll get the best terms, including the lowest interest rates. If you don’t have great credit, a home equity loan may offer better terms because of the collateral it provides.
When Should You Use a Home Equity Loan Over a Personal Loan?
Choosing a home equity loan over a personal loan is better for some people. Here’s how to tell.
Do you have a lot of equity in your home?
If you have equity in your home and you’ll be in your home for a while, taking the equity out can be financially smart. You get great terms because of the collateral, and you can do what you want with the funds.
Are you reinvesting in your home?
If you need the funds to renovate your home, taking money out of your home’s value makes sense. You borrow from the home to improve its value and have an even higher capital gain. Home equity loans are often taken out to renovate a kitchen or bathroom or add a room addition.
Do you have less than perfect credit?
You need decent credit to get a home equity loan, but it doesn’t have to be perfect. Because you are giving your home as collateral, you can get by with a lower credit score. Keep in mind, though, you’ll pay a higher interest rate to make up for the lower score, but you still have a chance of getting approved.
Are interest rates concerning you?
You’ll likely get a lower interest rate on a home equity loan than a personal loan. If you’re interest rate driven, you’ll find a home equity loan much more attractive.
>> More: Best Home Equity Loans
Alternatives to Personal Loans and Home Equity Loans
Credit cards can be a good source of funds but be careful. If you must use more than 30% of your total credit line, it can hurt your credit score. Credit cards also have high-interest rates, so if you need a while to pay the amount back, it could cost you a pretty penny to do so.
A cash advance is never recommended with a credit card. They are subject to much higher interest rates and fees that personal loans or home equity loans would definitely beat.
A cash-out refinance is a refinance of your first mortgage, but for a higher loan amount. Like a home equity loan, you can take into up to 80% of the home’s equity, but rather than taking out a second mortgage, it’s combined in one loan.
A cash-out refinance takes longer in underwriting than a personal loan, but you may find attractive interest rates with them, especially if you have good credit.
>> More: Best Cash-Out Refinance Lenders
Home Equity Line of Credit
A home equity line of credit (HELOC) is like a combined home equity loan and a credit card. You can borrow up to 80% of the home’s value, but you get it as a credit line or revolving debt. You can use the line for up to 10 years. You pay interest only on the funds you withdraw, and you don’t have to pay back the principal (if you don’t want to) for the first 10 years.
After the draw period ends, you enter the repayment period for 20 years. This is when you pay principal and interest on your loan, and you can no longer withdraw funds.
>> More: Best HELOC Lenders
A 401K loan is a loan against yourself. You borrow from the money you contributed (and earned) in your 401K, and you pay yourself back, including interest in 5 years or less. You can borrow up to 50% of your vested amount or $50,000, whichever is less.
Not all 401K plan sponsors allow 401K loans, so always check with your plan administrator first.
Is It Easier to Get a Personal Loan or Home Equity Loan?
It’s easier to get a personal loan because there’s no collateral and very little underwriting required. Home equity lenders must fully underwrite your finances (credit, income, assets, and liabilities) as well as your home value and title.
A personal loan lender evaluates your income and debts, looks at your credit score, and decides if you qualify for the loan. They can finish the process in a matter of days, whereas a home equity loan can take weeks.
Do Personal Loans, or Home Equity Loans Have Lower Interest Rates?
Home equity loans typically have lower interest rates because of the collateral you put up for them. The interest rate you pay depends on your qualifying factors, though. It’s best to compare your options based on what lenders will provide you to see what’s best.
>> More: Personal Loan Requirements
Bottom Line: Personal Loan vs. Home Equity Loans
Personal loans and home equity loans can be a great way to get the funds you need. You’ll pay interest on both, and they both have fees, but sometimes one is better than the other. Consider your circumstances, including why you need the funds and what you can afford to decide what’s right for you.