Deciding on what type of loan to use when borrowing money can be tough. Personal loans and loans based on your home's equity can be good choices when you have a home renovation project in mind or experience a financial emergency and need a sizable cash influx. But which is right for you?
While second mortgages in the form of home equity loans and home equity lines of credit (HELOCs) remain a popular way to fund home improvements, weddings and other large-scale expenses, consumers are increasingly using personal loans for these needs. Why? Personal loans typically offer a quicker way to access cash, and their interest rates have become more competitive in recent years. In addition, since the Great Recession in 2008 when mortgage defaults hit record highs, consumers have been more reluctant to leverage their homes. Still, home equity loans and HELOCs often offer better interest rates (because you're using your home as collateral) and are tempting funding sources when you have a lot of equity in your home.
Home equity loans and personal loans are similar in structure: You borrow a set amount of money which you receive in a lump sum, and you pay the loan back with fixed payments. Interest rates are also typically fixed and not variable. If you're comparing these two, it may simply come down to which offers the better interest rate.
HELOCs, however, differ in that interest rates are usually variable, and you are approved for a credit line up to a certain limit. If you're deciding between a HELOC and a personal loan, you need to consider how quickly you need the cash, how you want to access the money, and whether you're comfortable using your home as collateral. Here's a look at HELOCs and personal loans to help you decide which one might be right for you.
What Is a HELOC?
A home equity line of credit, or HELOC, is a loan based on your home's value beyond what you owe on it. A HELOC is a line of credit just like a credit card, where you are approved for a certain amount and you can borrow up to that limit for a period of time—often 10 years—called the draw period. During the draw period you may pay interest-only or minimum payments, followed by the repayment period once your draw period ends. You typically access your HELOC funds with a debit card or check.
To apply for a HELOC, you usually need at least 20% equity in your home and good credit. HELOCs require a home appraisal, lengthening the approval process, which often takes at least 30 days.
Because the lender uses your house as collateral, HELOC interest rates tend to be lower than personal loan interest rates, and often lower than fixed-rate home equity loans, at least in the beginning. But keep in mind, rates on most HELOCs are variable, meaning they can fluctuate over time based on market rates. For this reason, HELOCs tend to be best if you plan to pay off the loan over a short period of time, before interest rates rise—and if you know you will keep up with payments to avoid default and possible foreclosure. If you plan to use your HELOC funds for a major home renovation, you'll likely get a mortgage interest deduction at tax time.
Over the past decade, outstanding balances on HELOCs have slowly declined, while available HELOC limits that remain unused continue to grow.
What Is a Personal Loan?
As with a HELOC, a personal loan can be used for just about anything. While in the past consumers primarily used personal loans for debt consolidation, such as paying off credit card balances, today personal loans are used for a variety of purposes.
Personal loans are unsecured, which means they don't have any collateral backing them, such as a house or car. Because unsecured loans are riskier for lenders, interest rates are usually higher than they would be for a secured loan such as a HELOC—but this isn't always the case. Interest rates for personal loans currently range from around 6% to 36% and depend on the loan amount, length of the loan term and your credit scores. If you don't want to use your house as collateral, even a slightly higher interest rate on a personal loan may be worth it to you.
If you need your cash infusion quickly, a personal loan may be a better option than a HELOC, as many online and other lenders today will approve personal loans within a week. This could partly account for the increase in personal loan balances, which have grown 57% in the past five years, making personal loans the fastest-growing consumer debt.
Which Loan Is Better for You?
Determining which type of loan is better really depends on you and your own situation. Both loans have their benefits and risks associated with them, including the time it takes to get approved, collateral needed and interest rates.
Ask yourself whether you are willing to take on a loan with a higher interest rate and receive money right away with a personal loan versus waiting a little longer to receive approval on your loan at a lower interest rate with a HELOC. Putting up your home as collateral may make you nervous as well, and if so, then you might want to consider a personal loan instead. If you don't need to borrow a lot of money, a personal loan may suit your needs better.
Whichever loan you choose, do your research to check the terms, length of the loan and interest rates. Lenders are there to answer your questions, so don't be afraid to ask as many as you need while you research the best loan option for you.