Home Equity Loan or Personal Loan? Which Is Best for You?

Unless you've been living off the grid in the woods, you've probably heard news regarding the recent increase in home values. And if you own a home, that likely means you have more equity than ever before in your house. If you're considering accessing some of the equity to cover a large expense, you'll want to read this first. A home equity loan may be your best option. However, it's also possible that a personal loan is your best bet.

Home equity loan

The equity in your home is the amount the property is worth minus any money you still owe. For example, if your home is worth $300,000 and you still owe $150,000 on the mortgage, you have $150,000 in equity. With a home equity loan, a bank typically allows you to borrow up to 80% of your equity. While a home equity loan can be used to pay for anything from a kitchen remodel to a European vacation, the loan comes with pros and cons.

Pros

• Generous repayment terms: Depending on the amount borrowed, you could have five to 30 years to repay the loan. While most give the borrower from five to 20 years, some are extended further.
• Lower interest rate: Because you're using real estate as collateral, you'll almost always score a lower interest rate with a home equity loan than an unsecured personal loan.
• Fix payments: The payments on a home equity loan are fixed and will never change.
• May be tax deductible: If you use the home equity loan to improve your property, interest payments may be tax deductible.

Cons

• Your home is on the line: A lender offers you a lower interest rate on a home equity loan because it knows that if you fail to make payments, your home serves as collateral. That means the lender can repossess the property, sell it, and recoup its losses.
• You'll have two mortgage payments: If you still have a primary mortgage, you must continue to make payments on that loan. Once you have a home equity loan, too, you'll have two monthly payments due on the house.
• You can expect to pay closing costs: Like almost any loan associated with real estate, you'll have to pay closing costs of 2% to 6% of the loan amount. If you borrow $100,000, your closing costs will be between $2,000 and $6,000.
• You'll need strong credit: According to Experian, you'll likely need a FICO® Score of at least 680 to qualify for a home equity loan. Some lenders prefer a credit score of 720 or more.

Personal loan

A personal loan is money you borrow from a lender that can be used in any way you see fit. For example, you can use a personal loan to put a new pool in the backyard, to pay for a 50th wedding anniversary celebration, or to consolidate existing debt. Most personal loans require no collateral, meaning you won't have to put anything of value at risk.

Personal loans are available through online lenders, local banks, and credit unions. It's paid in one lump sum, and you'll make monthly payments until the loan is repaid in full.

However, like home equity loans, there are both pros and cons associated with personal loans.

Pros

• Fast funding: Once approved for a personal loan, the lender may deposit the money in your bank account as soon as the next business day. This is especially helpful if you're borrowing money to cover an emergency situation.
• No collateral: Most personal loans do not require collateral, but if you work with a lender that will allow you to put something of value up as collateral, you'll probably score a lower interest rate. Again, it's because the lender knows that it has something it can repossess and sell if you stop making payments.
• Lower interest rate than most credit cards: While it's not always the case, personal loans typically offer a lower APR than credit cards. This is particularly true if you have a strong credit score.
• Low fees for those with high credit scores: Those with the highest credit scores can usually land a personal loan with no origination fee and few (if any) other fees.
• Ability to pay off quickly: Many personal loans have no prepayment penalty. This means you're free to pay the loan off as soon as possible without shelling out extra money.

Cons

• May find lower interest rates elsewhere: With a good to excellent credit score, you may find a better interest rate by borrowing against your home or taking out a credit card with a 0% promotional rate.
• Fees can be costly: If your credit score is lower than you'd like, you may find yourself with a personal loan that charges all kinds of expenses, from origination to late fees.
• Adds to your debt-to-income level: The lower your debt-to-income (DTI) ratio, the more attractive you are to borrowers. DTI measures how much you owe against how much you bring in each month. Taking out a personal loan can raise your DTI.

Determining which loan is right for you

When you're looking to borrow money, the first step is determining which type of loan will benefit you the most. For example, if you want to add a new addition to your home and need up to 30 years to repay the loan, a home equity loan is your best option. That's especially true if you're eligible to take the interest deduction on your tax return.

On the other hand, if you only need enough money to replace a 25-year-old furnace or make car repairs, a personal loan may be the best bet due to the speed of funding. And if your credit score is not high enough to qualify for a home equity loan, a personal loan may be the only game in town.

Explore both options by speaking with your bank or credit union. Once you've nailed down which type of loan fits best, borrow only what you'll need to cover the project. You'll thank yourself for not taking out more than necessary when the loan is repaid in full.