Home Equity Loan vs. Personal Loan:An Overview
A home equity loan and a personal loan both offer one-time, lump-sum payments that are required to be paid back in installments over an agreed-upon period of time. However, the main difference is that home equity loans are a specific form of secured loan in which the borrower’s home is used as collateral. Personal loans, on the other hand, can be secured or unsecured by collateral and are a much broader and varied category.
As personal loans tend to have a less intensive approval process than that of a home equity loan, they can generally be quicker and more straightforward to obtain. While home equity loans usually will take longer to be approved, they tend to offer a lower interest rate than a personal loan and potentially a higher loan amount as well. Before pursuing either option, however, it’s important to consider the amount you need and the intended purpose of your loan.
Key Takeaways
- Home equity loans and personal loans both offer lump-sum payments to be paid back in installments over a specified time period.
- A home equity loan is a type of secured loan in which the borrower’s home is used as collateral, whereas personal loans can be secured or unsecured by collateral.
- Personal loans tend to be quicker and more straightforward to approve, while home equity loans require a property appraisal and a lengthier application and approval process.
- Home equity loans usually offer a lower interest rate than personal loans, but both usually offer lower interest rates than credit cards.
- Both loan types can be used for a variety of purposes, though home equity loans can offer larger amounts, depending on the borrower’s home equity.
Loan Structure and Purpose
In a home equity loan, money is borrowed using the value of your home (more specifically, your home equity) as collateral. The Federal Trade Commission (FTC) defines home equity as “the difference between what you owe on your mortgage and how much money you could get for your home if you sold it.” This is why a home equity loan is sometimes referred to as a second mortgage.
Many personal loans are unsecured, but secured personal loans, which can be backed by collateral like a certificate of deposit (CD), stocks, a vehicle, or savings, are also available.
Personal loans can be used for a variety of purposes, including consolidating credit card debt, paying off higher-interest debt, paying for large expenses (such as a major home appliance or a vacation), or even establishing or improving your credit score.
Home equity loans also can be used for a range of purposes, such as debt consolidation, large one-time expenses, or educational or medical expenses. Keep in mind that a home equity loan is a lump-sum payment, so a home equity line of credit (HELOC) may be a better fit for situations (such as a lengthy home renovation project or starting a business venture) where a large amount of ongoing funding is required or money will be needed continually over a period of time.
In considering which loan to access for financing in the specific case of home renovations or improvements, a home equity loan may be a better option than a personal loan. This is because in most cases, the interest paid on personal loans is not tax deductible; however, home equity interest payments are—on the condition that the home equity loan is used to “buy, build or substantially improve the taxpayer’s home that secures the loan.”
Loan Application and Approval
Personal Loan Application and Approval
When applying for a personal loan, the following usually will be taken into consideration by the lender:
- Your credit score and credit report
- Your income and employment status
- Any debt you may have (specifically, your debt-to-income (DTI) ratio)
- The interest rate permitted by the applicable state law
- Collateral (if applying for a secured loan)
The loan amount and the length of the repayment term are also important factors that will determine the loan's interest rate.
Keep in mind that personal loans may also include fees such as:
- Origination fee
- Fees for processing documents and paperwork
- Credit insurance (optional)
- Disability insurance (optional)
- Non-filing insurance (for secured loans)
- Late penalty fees
Home Equity Loan Application and Approval
When you apply for a home equity loan, a lender will calculate your loan-to-value (LTV) ratio or combined loan-to-value (CLTV) ratio to consider how much money they will allow you to borrow. This calculation essentially answers this question: If the house is sold, would it cover the amount owed by your original mortgage and this additional loan, and by how much? It is also a large factor in determining the interest rate of your loan. Usually, the lower your LTV, the lower your interest rate.
To determine the value of your home, there is usually an appraisal process similar to that of getting a conventional mortgage. This can entail various fees and closing costs. Your income and credit history also will be taken into consideration. The maximum amount that you can borrow is usually equal to around 80% of your home equity. Keep in mind that lenders may have a minimum amount that they will lend in this type of loan agreement.
Interest Rates and Payment Terms
The interest rate on a personal loan can be fixed or variable, and it can be lower than that of a credit card but usually higher than that of a home equity loan (especially in the case of unsecured personal loans). In general, evaluate a personal loan interest rate by comparing it to the national average: If it’s lower, that’s a good sign. Personal loan terms can range in length—it’s advisable to choose the shortest loan term for which you can afford monthly payments.
Home equity loan interest rates are usually fixed, and they tend to be lower than both personal loans and credit cards because the home is used as collateral. However, the risk here is that if the loan is not paid off, the lender can repossess and sell the home to cover the remaining debt. It also means that if the value of your home decreases, you may end up underwater—the amount that you owe may exceed the value of the home.
Other Considerations
When considering any loan, it’s important to shop around and compare the terms and deals offered by different banks, credit unions, and financial companies. Under the Truth in Lending Act (TILA), lenders are required to disclose the following information before borrowers sign any loan agreement so that they can understand and compare different offers:
- The full amount you are borrowing
- Repayment amounts and their due dates
- How much it costs to borrow the money (referred to as the finance charge and includes interest and any fees applicable to the loan)
- The annual percentage rate (APR)
- Any penalties that may apply for late payments
- The consequence(s) of not paying back the loan and actions that the lender may take
- Any penalties that may apply for paying the loan back early
Try using a loan calculator to get an idea of how much you’ll end up paying.
How Do People Use Personal Loans?
Investopedia commissioned a national survey of 962 U.S. adults between Aug. 14, 2023, to Sept. 15, 2023, who had taken out a personal loan to learn how they used their loan proceeds and how they might use future personal loans. Debt consolidation was the most common reason people borrowed money, followed by home improvement and other large expenditures.
What Is the Difference Between a Personal Loan and a Home Equity Loan?
The biggest difference between a personal loan and a home equity loan is the structure. A home equity loan is a specific type of secured loan that uses the borrower’s house as collateral. While both offer lump-sum payments, the amounts for each can vary, and the approval process is different (usually significantly shorter in the case of personal loans).
What Is the Downside to a Home Equity Loan?
Perhaps the biggest downside of a home equity loan is that your house is used as collateral. If you default on the loan, then your lender may be able to seize your home.
Does a Personal Loan Have Lower Interest Rates Than a Credit Card?
Personal loans can have lower interest rates than a credit card, but not necessarily. It will depend largely on the length and type of the loan (e.g., secured vs. unsecured) as well as the borrower’s credit history.
The Bottom Line
In considering whether to pursue a personal loan vs. a home equity loan, it’s important to determine whether either option is best for your financial situation (or whether another type of credit, such as a line of credit or a refinancing option, might be more suitable). Use a loan calculator to get an idea of how much you will potentially be spending. Considering the purpose of the loan and the amount that you’ll need, shop around for the best options among various lenders, and ensure that you understand the entire agreement and any associated fees before signing anything.
