Sometimes, borrowing money can be the key to meeting your personal or financial goals — as long as you do so responsibly.
Personal loans and home equity loans are two of the most popular financing options on the market. Both are installment loans that give you a lump sum upfront, to be paid back with interest through fixed monthly payments over a period of time. Both can be used for virtually anything, from home improvements to covering emergency expenses to consolidating other debts.
The key difference lies in each loan’s secured or unsecured nature and how that affects the rates and terms lenders offer.
Here’s everything you need to know about personal loans vs. home equity loans and how to choose the right option for your financial needs.
How Do Home Equity Loans Work?
With a home equity loan, you borrow against your home equity — your house’s current value minus what you owe on your mortgage. Home equity loans have fixed interest rates and repayment terms, meaning you’ll repay the loan in fixed installments over a period of five to 30 years.
Home equity loans are secured loans, which gives them certain advantages, says Danielle Miura, a certified financial planner (CFP) and owner of Spark Financials. “Because the home is used as collateral, it’s less risky for the bank,” she says. Because of this, home equity loans typically have lower interest rates than personal loans or credit cards.
Whether you choose a personal loan or a home equity loan, be sure to compare rates and fees from multiple lenders to find the best deal.
How much you can borrow with a home equity loan depends on how much equity you have in your house. When evaluating your application, a lender will look at your combined loan-to-value ratio (CLTV), which is calculated by dividing all the total debts secured by your house (including your primary mortgage and any home equity loans or home equity lines of credit associated with your house) by your home’s appraised value. Most banks and credit unions will allow a maximum CLTV of 80% to 85%, meaning you need to keep at least 15% to 20% equity in your home.
For example, let’s say you own a $250,000 home and owe $150,000 on the mortgage. You have $100,000 in home equity, and your current CLTV is 60%. If your lender allows a CLTV of 85%, you could borrow up to $62,500 with a home equity loan.
Your credit score, monthly income, and debt-to-income ratio can also influence whether you qualify for a home equity loan and what interest rate you get.
Home equity loans may come with closing costs ranging from 2% to 5% of the loan balance. These closing costs can include appraisal fees, origination fees, attorney fees, title search fees, and more.
How Do Personal Loans Work?
Personal loans are typically unsecured, so you don’t have to provide your property as collateral. Instead, personal loans — also known as signature loans — are issued based on your creditworthiness. Lenders look at your credit score, credit history, and income when deciding whether to offer you a loan.
Unsecured personal loans are offered by banks, credit unions, and online lenders. You can usually apply for personal loans online and receive a decision the same day you apply. If you’re approved, the lender can deposit the money directly into your bank account.
Personal loans have fixed repayment terms, and you’ll typically make fixed monthly payments for two to seven years. When you apply for a personal loan, you’ll usually have multiple loan options to choose from, so you can pick the loan term and monthly payment that works best for your financial situation.
Borrowers with lower credit scores may have difficulty qualifying for a personal loan or may find themselves with a higher interest rate. On the other hand, those with excellent credit will likely get better rates and terms.
While a personal loan isn’t secured and you won’t lose your property if you default, it’s still important to make on-time payments. Otherwise, the lender can report your late payments to the credit bureaus or send your debt to collections. That can severely damage your credit score and have other consequences.
Personal loans don’t have closing costs, but be sure to read the fine print. Some lenders charge origination fees — which can be as high as 6% of the loan amount — which are deducted from the loan total before the funds are disbursed. Other lenders may charge prepayment penalties if you pay off your loan early.
When Should You Choose a Personal Loan?
Whether a personal loan or home equity loan is better for you depends on your credit, the amount of money you need, and how quickly you need it. A personal loan makes the most sense in the following scenarios:
- You need money fast: Home equity loans can take weeks to process. “You have to worry about evaluating the property [with a home equity loan],” says Miura. “And there’s more paperwork and due diligence involved with a home equity loan. Therefore it may take a month or more to process.” If you need money quickly to cover an emergency expense — such as a sudden vet bill, a car repair, or a major medical procedure — you may not have the time to wait. With personal loans, you may be able to get the money much faster. Some lenders offer loan disbursements as soon as the same day you apply, but most personal loans are available within one to five business days.
- You need a smaller amount of money: Although there are some exceptions, personal loans tend to have maximum loan amounts of $50,000 or less. If your planned expense is under that amount, a personal loan could be a good choice. If you need more funding, such as for a large home improvement project, you might need to use a home equity loan instead.
- A secured loan makes you nervous: With a home equity loan, your house is your collateral. If you miss payments, lenders could start foreclosure proceedings against you. If that seems too risky for you, an unsecured loan is probably a better option even if it might come with a higher interest rate.
Pros and Cons of a Personal Loan
When Should You Choose a Home Equity Loan?
Darcy Borella, a CFP and financial advisor with Maia Wealth, says home equity loans pose less risk to lenders. “With a home equity loan, the equity within your home is securing the loan,” she says. “So the banks will see that as a less risky or a lower risk investment on their part than a [personal] loan.”
Because of the reduced lending risk, home equity loans tend to come with lower interest rates and larger loan amounts, which are the primary benefits to borrowers.
If you’re a homeowner, a home equity loan can make more sense than a personal loan in the following scenarios:
- You’ve established sufficient equity: To qualify for a home equity loan, you need to have established at least 15% to 20% equity in your home. This could be the case if you had a larger down payment, you’ve lived in your house for a while and have paid down the mortgage, or if home values have significantly increased in your area.
- You need a large amount of money: Home equity loan lenders typically allow you to borrow up to 85% of the available equity in your home. If your house has increased in value or you’ve paid down a significant portion of your mortgage, you may be able to take out a much larger sum than you’d get with a personal loan.
- You want lower monthly payments: Home equity loans can have repayment terms as long as 30 years. While a longer loan term will cost you more in total interest paid over the life of the loan, it will also give you a much smaller monthly payment than you’d get with a personal loan with a five-year term. A lower monthly payment may help you stay within your budget.
- You want to pay for education expenses: Most personal loan lenders forbid you from using the money for education expenses or student loans. Home equity loans don’t have those restrictions; you can use your loan to pay for a child’s college education or pay off your own student loans. However, experts recommend maxing out financial aid and federal student loans before turning to any private option, including personal loans and home equity loans.
- You plan on using the money for home renovations: If you plan to use borrowed funds for home renovations, there are tax advantages if you use a home equity loan. “If you’re considering doing a remodel or an addition on your home and it’s going to improve the value of your home, I would do a home equity loan or home equity line of credit for that purpose,” says Borella. “You’re able to potentially get a tax deduction, if you itemize for the interest on the loan, because you’re going to be improving the value of the home.”
Pros and Cons of a Home Equity Loan
Larger loan amounts possible
Home equity loan rates tend to be lower
Longer repayment terms available
Fewer restrictions on loan use
Interest may be tax-deductible if you use the funds for qualified home improvements
You may not have enough equity in your home
Home equity loans can take weeks to process
Your home acts as collateral
You may have to pay closing costs
Alternative Borrowing Options
By understanding the benefits and drawbacks of personal loans and home equity loans, you can decide which is best for you. But what if you realize neither is a good option for your needs? There are other financing options that could be a better fit:
Home Equity Line of Credit (HELOC)
Like a home equity loan, a home equity line of credit (HELOC) allows you to borrow against your home’s equity. HELOCS are a form of revolving credit, meaning you get access to a line of credit you can tap into repeatedly, rather than receiving the entire balance at the onset of the loan. During the draw period, you can borrow money as much as you want, whenever you want, up to the credit limit. Afterward, during the repayment period, you’ll pay back only what you used, plus interest.
Unlike fixed-rate home equity loans, HELOCs traditionally have variable interest rates, meaning your rate and monthly payments could change unexpectedly if market interest rates change. However, some lenders offer a rate-lock option on their HELOCs, which could be beneficial in a rising interest rate environment.
Because of their flexible nature, HELOCS make sense when you don’t know the exact amount you need, or if you think you’ll need money for ongoing expenses.
With a cash-out refinance mortgage, you apply for a new home loan that is larger than the balance on your existing one. The new loan pays off your current mortgage, and you get the difference as a lump sum cash payment. Like a rate-and-term refinance or a new mortgage, a cash-out refinance typically comes with substantial closing costs.
Unlike home equity loans, which are second mortgages on top of your existing mortgage, a cash-out refinance replaces your primary mortgage with a new one, with a new interest rate and loan term. Cash-out refinance rates are tied to mortgage rates, which reached historic lows during 2020 and 2021 but have steadily risen since. Borrowers who recently refinanced may not want to replace their existing mortgage — and its relatively low rate — with a new loan.
0% APR/Balance Transfer Credit Card
If you want to consolidate credit card debt to save money on interest, a balance transfer card with a promotional 0% APR offer may be better than a personal loan or home equity loan.
Available to people with good credit, a balance transfer card allows you to transfer the balance of one credit card to another. You can get 0% APR for the length of the promotional period, which is typically six to 18 months, giving you time to pay off your debt without interest charges.
After the introductory offer ends, the regular APR applies and your remaining balance will accrue interest. Be sure you have a plan to pay off your debt completely before then, or you’ll be facing high credit card APRs.
A 0% APR credit card can be useful if you have good credit and a relatively small amount of debt that you can pay off in full within the promotional period.