Personal loan or home equity loan: Which is better?

Before heading to the bank, it's important to know the distinctions between a home equity loan and a personal loan. (iStock)

From time to time, many of us may encounter a situation where we need extra money. Perhaps you want to make improvements to your home or cover an unexpected emergency? If your savings account doesn’t have sufficient funds, you could be shopping around for a loan.

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Depending on your financial situation, two common options are a home equity loan or personal loan. To make the best choice, it’s a good idea to understand each one.

Home Equity Loan

A home equity loan is an amount you can borrow based on the equity you have in your house. It’s calculated by subtracting the balance of your existing mortgage from the value of your home.

The application and approval process is similar to obtaining a mortgage, including an appraisal of your property. Home equity loans provide borrowers with a lump sum that is paid back in equal installments over time, ranging from five to 30 years.

HOW DOES DEBT CONSOLIDATION AFFECT YOUR CREDIT SCORE?

A home equity loan is sometimes called a “second mortgage” and your home serves as collateral. If you fail to make the payments, the lender can foreclose on your property. Just like with first mortgages, rates, fees and closing costs can vary. The U.S. Housing Department of Housing and Urban Development recently announced it would restrict the amount you can borrow from 85 percent of a property’s value to 80 percent.

Personal Loan

A personal loan is a fixed amount that a financial institution lends you. The most common uses for personal loans are debt consolidation, home improvements, or unexpected expenses and large purchases, according to U.S. News & World Report.

The amount you may borrow will depend on your credit score as well as your current level of debt. Like a home equity loan, a personal loan is paid back in equal installments over time, often between two and five years and usually at a fixed rate.

HOW PERSONAL LOANS AFFECT CREDIT SCORES

While some personal loans are secured, borrowers with good credit history can be approved for an unsecured loan. Personal loan interest rates can be higher than those for home equity or car loans, but lower than many credit cards. Online loans may offer the best rates. Personal loan rates can range widely depending on your credit score.

Knowing Which to Choose

While a home equity loan or personal loan can be used for similar reasons, each has advantages and disadvantages that can make one a better choice, depending on your situation.

Home Equity Loan Pros

  • You can choose a longer-term loan and have more time to pay back the balance.
  • Depending on the amount of equity in your home, you can qualify for a larger loan.
  • Because they’re secured, home equity loans usually have lower interest rates than personal loans.
  • Your interest may be tax-deductible, depending on how the funds are used.

Home Equity Loan Cons

  • Due to a more complex application process, it can take two to six weeks to receive funds.
  • If you live in an area where home prices start to decline, you could end up owing more on your home than it’s worth.
  • You put your home at risk in case you are unable to make your payments.
  • The Tax Cuts and Jobs Act of 2017 restricted the home-equity loan tax deduction, making this type of loan less desirable for some homeowners.

Personal Loan Pros

  • You can often obtain funds quicker than with a home equity loan.
  • You don’t need to own a home to qualify.
  • You can borrow smaller amounts.
  • You don’t put your home at risk.

Personal Loan Cons

  • If you need a large amount of money it may be more difficult to get the funds you want.
  • If you have a low credit score or a lot of existing debt, it may be difficult to qualify.
  • Interest rates are often higher than home equity loans.

Making the Right Choice

The type of loan that’s right for you will depend on how you plan to use the funds, your credit history and your ability to repay the balance. Each has benefits as well as risks. Whichever you choose, shop around for the best rates and terms so you can get the money you need in a way that benefits your financial situation in the long run.