Home Equity Loan vs Personal Loan: Which One Is Better?
Posted on February 3, 2021 in Loans
There are many options available when it comes to borrowing money. Some of the most popular loans are home equity loans and personal loans. And though they are similar, there are several factors to consider when deciding which one of these loans is best for you.
What Is A Home Equity Loan?
A home equity loan is a secured loan for a fixed amount of money in which the home itself is collateral. The loan is broken down into equal monthly payments that are paid off over a fixed amount of time measured in years or decades, depending on the terms of the loan contract. If the loan isn’t repaid adequately under contract terms, then the lender could potentially foreclose on the home.
The maximum borrowable amount is usually limited to 85% of the home’s equity, but factors such as income, credit history, and home market value may also contribute. Additionally, these factors influence the loan’s interest rate.
Currently, the average interest rate for a 15-year home equity loan is 5.82%. Generally speaking, this is a much lower interest rate than most other loan types, but this is because of the foreclosure risk in the event of non payment.
What Exactly Is Equity?
In order to take out of a home equity loan the borrower must have equity in a home to borrow from. Anyone that owns a home and has made payments on their mortgage will have created home equity. Equity is the difference between the remaining mortgage balance and what the home is currently valued.
For instance, if a home is valued at $250,000 and the remaining mortgage is $150,000 then the equity would be $100,000. Now a home equity loan is rarely ever given for the full amount of the equity and other factors can contribute but normally 85% of the equity is the maximum amount available to borrow.
What Is A Personal Loan?
Personal loans are, most often, unsecured loans that come with fixed terms in both interest rates and repayment. The range for repayment can last anywhere from a few months to several years but rarely will they last more than seven years.
With most personal loans, the debt is considered “unsecured” meaning that nothing is put up as collateral to back the loan. This means that failure to pay back the loan according to the agreed-upon terms will not result in the forfeiture of any assets or property.
Because of this, the banks, credit unions or online lenders take a deep dive into the loan applicant’s financial details. Credit score, income and credit report usually dictate loan terms. This process can make it difficult for people with bad credit to get a loan. The range of interest rates for a personal loan is between 6% and 36%, but the average is currently 9.41%.
What Are The Similarities?
There are a few similarities between a home equity loan and a personal loan. The most significant similarity is that payments are broken down into fixed monthly payments for an agreed amount of time. One of the benefits of taking out loans in this form is the impossibility of running up any more debt. The borrowed amount is a one time deal and any additional borrowing will require a new loan application with new specified terms.
Alternatively, one could open a line of credit, which is more-or-less an open-ended loan with no fixed terms, making the borrower susceptible to even more loan repayment than they started with. This is simply not possible with fixed loans.
Additionally, fixed interest rates will be added into the monthly payments, so no hidden fees or other variables will pop up unexpectedly. These types of loans also have some of the lowest interest rates on average when compared to other types of loans.
What Are The Differences?
Now that we have established the similarities between home equity and personal loans, we can look at their differences in more detail.
Secured Vs Unsecured
Home equity loans are secured, and personal loans are generally unsecured. If a borrower defaults on a personal loan, their credit score may drop significantly, which can make applying for future loans very difficult. Additionally, the lender or debt collector may file litigation against the borrower. The borrower could have their wages garnished or liens placed on other accounts. These are extreme scenarios, but they are possible. Concerning home equity loans, the consequences can be just as severe; if a borrower defaults on a home equity loan, the lender could begin foreclosure proceedings.
As a result of being a secured loan, the interest rate on a home equity loan will generally be much lower than a personal loan. There are a variety of factors that determine interest rates for both types of loans. Home equity loans, because the home is acting as collateral, tend to have lower interest rates compared to personal loans.
Unsecured loans present a higher risk for the lender because repayment is less likely. To offset this risk, the borrower can apply for a loan with a higher interest rate. The length of the loan can also play a factor on the interest rate. Typically, the interest rate will be lower when the period for loan repayment is more extensive (e.g., three years as opposed to three months).
Amount Available and Term Lengths
While personal loans are usually set somewhere between $1,000 to $50,000, a home equity loan can range in the hundreds of thousands of dollars. The larger the sum of the loan, the longer it will take to pay back.
Because of this, the repayment schedule on home equity loans can be much longer than that of personal loans. In most cases a personal loan will range from 12 to 60 months, but a home equity loan is anywhere from 5 to 30 years.
Which One Is Better?
The answer to this question depends on the individual and their goals. Home equity loans are strictly for home owners. Borrowers who don’t own property will have to stick to personal loans. For home owners applying for home equity loans, the biggest question usually is: How much should I ask for?
Personal loans are good for quick and easy payments of a few thousand dollars, but a home equity loan is the better option if the borrower is in need of tens of thousands of dollars. Ultimately, any individual borrowing money will have to decide which option is best for them.
While personal loans and home equity loans are solid options for short- and long-term borrowing, you should research both and determine which one is best for your financial goals.
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