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When it comes to versatile, affordable and widely available loan products, it’s hard to beat a personal loan or home equity loan. But how do you know which one to choose?
This answer depends on a number of variables, many of which relate to your particular financial situation. We’ll break down the pros and cons of both loan types so you can get a better idea of which one is right for you.
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What is a personal loan?
Personal loans are unsecured loans that require no collateral – something of value that secures the loan and that the lender can take back if you don’t repay. Mortgages, home equity loans, and auto loans, where the loan is directly tied to an asset, are examples of secured loans.
You can use personal loans for a variety of different expenses, including:
- Debt Consolidation
- Wedding expenses
- Home improvement
- Medical fees
- Finance a major purchase like a boat or a car
Personal loan repayment terms vary between one and seven years, depending on the lender. In general, the longer the term, the higher the interest rate. Most personal loans have fixed interest rates between 4% and 36%. Also, limits generally range from $500 to $50,000, but some providers lend up to $100,000.
Your interest rate and the amount you can borrow depends on your credit score, income, and any other outstanding debt.
How Personal Loans Work
Once you’ve applied for a personal loan, it usually takes anywhere from a few minutes to a week to receive a decision, depending on your lender. Lenders generally require a minimum credit score of 660, and they may also have an annual income threshold that the borrower must meet.
If you are approved, the lender will transfer your funds as a lump sum to your bank account, usually within a few days. Repayment begins immediately after the loan is disbursed and you pay interest on the full loan amount whether you use all or part of it.
Some lenders will also charge personal loan origination and prepayment fees, but this varies from lender to lender.
Related: 5 personal loan requirements to know before applying
When to choose a personal loan
A personal loan works best if you only need to borrow a few thousand dollars and want a hassle-free loan application process. You can also benefit from a low interest rate if you have excellent credit. Also, if you don’t have equity in your home, you won’t qualify for a home equity loan, which makes a personal loan the right choice.
Related: Best Personal Loans
What is a home equity loan?
A home equity loan is a secured loan that uses the accumulated equity in your home – the current market value of your home minus the remaining mortgage balance – as collateral. Most lenders require you to have a net worth of at least 15% to 20% and a minimum credit score of 620. You can borrow up to 85% of your net worth and repay it over a period of five to 30 years.
How home equity loans work
If you have at least 15% to 20% equity in your home, you may qualify for a home equity loan. Homeowners can contact their mortgage lender or other loan broker and apply for a home equity loan. At closing, you will usually have to pay fees and closing costs between 2% and 5% of the total loan amount. Some lenders may waive these additional fees.
The home equity loan is secured by your home, making it secondary to the mortgage. The loan is then disbursed in a lump sum and you have to pay interest on the entire loan balance. Since your home secures the loan, the lender can foreclose if you fail to make the payments on time.
When to Choose a Home Equity Loan
If you don’t qualify for a low interest rate on a personal loan and have enough equity in your home, consider a home equity loan. Since home equity loans use your home as collateral, interest rates are lower than personal loans.
If you use the proceeds for a home repair or renovation project, you can deduct the interest paid on the home equity loan from your taxes, which is not an option with a personal loan.
Related: Best Home Equity Lenders
Advantages and disadvantages of personal loans
Advantages of Personal Loans
- Approval takes less time compared to a home equity loan.
- There is no risk of having assets repossessed by the bank if you default.
Disadvantages of personal loans
- Interest rates can be high, depending on the amount you borrow and your credit score.
- Some lenders charge prepayment penalties if you repay the loan early.
- Repayment terms are shorter than home equity loans, which means monthly payments can be higher.
Advantages and disadvantages of home equity loans
Benefits of Home Equity Loans
Disadvantages of home equity loans
- Borrowers who default can have their homes repossessed.
- It may take a few weeks to obtain funds, similar to closing a house.
- Some lenders have high minimum loan amounts, which may be more than you need.
- Closing costs are often high.
Alternatives to Personal Loans and Home Equity Loans
If you need money, there are options other than a personal loan or a home equity loan.
Borrowers who don’t need a lot of cash should consider a credit card, especially if they qualify for an interest-free financing card. These offers usually last for six months or up to 21 months. Any outstanding balance at the end of the promotional period will start earning interest until it is fully paid off. Even if you can’t pay off the entire balance within that time, you can still pay less interest than if you had taken out a personal loan or home equity loan.
Credit cards also offer more flexibility because the minimum payment is almost always much lower than it would be for a personal or home equity loan. For example, if you lose your job or have an emergency, it’s easier to pay a minimum credit card payment than a personal loan or home equity loan.
If you need access to cash, you can take out a cash advance with your credit card. However, the card provider will usually charge a cash advance fee, usually between 3% and 5% of the transaction amount, in addition to an annual percentage rate (APR). Interest on the cash advance will begin to accrue immediately. Cash advance interest rates are higher than a regular credit card transaction, often up to around 30% APR.
Home equity line of credit
Like a home equity loan, a home equity line of credit (HELOC) uses the equity in your home as collateral; however, instead of a lump sum, a HELOC gives you a limit that you can use as needed.
HELOCs consist of two parts: the draw period and the redemption period. The drawdown period refers to when you access the funds. During the drawdown period, a borrower is only responsible for paying interest on the money they borrow. Once the drawdown period ends, usually after 10 years, the repayment period begins. The repayment period usually lasts 20 years and the borrower has to make monthly payments on the principal and interest borrowed.
Like home equity loans, HELOCs come with closing, appraisal, and origination fees, and you need between 15% and 20% of your home’s equity to qualify.
If you have a current 401(k), you can borrow against the balance and use the funds to pay off debt, go on vacation, or make home repairs. The maximum amount you can borrow is $50,000 or 50% of your acquired balance, whichever is less.
Unlike other types of loans, a 401(k) loan has no minimum credit score or income requirement. Interest assessed on a 401(k) loan will be deposited into your account, as if you were paying yourself interest.
Only investors confident in their job security should take out a 401(k) loan. If you are laid off or fired, you will have to repay the money no later than the next tax day. If you cannot afford it, the remaining balance will count as a withdrawal. Borrowers under the age of 59.5 will have to pay a 10% penalty and income taxes.
Refinancing by collection
If you have at least 20% equity in your home, you can refinance and remove excess equity from your home. You can use this money for several different reasons, such as paying off other loans, renovating your existing home, or buying another property.
When you do a cash-out refinance, you receive a new mortgage with a different term and interest rate. The total balance will also be higher than the previous balance, and you could end up with a higher monthly payment if interest rates are higher now than when you first took out the loan.