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Taking out a loan is often necessary to cover large expenses or consolidate debt Two common options are personal loans and home equity lines of credit (HELOCs) But how do you decide which is the better choice for your situation?
I’ve taken a close look at personal loans versus HELOCs to highlight the key differences and help you determine which is likely to be the better fit.
What is a Personal Loan?
A personal loan is an installment loan, meaning you borrow a lump sum of money upfront and repay it in fixed monthly payments over a set period of time
Personal loans are usually unsecured meaning they are not backed by any collateral. Instead lenders assess your creditworthiness and income to determine if you qualify.
The typical personal loan amount ranges from $1,000 to $50,000, though some lenders offer up to $100,000. The better your credit score and income, the higher loan amount you may qualify for.
Personal loans have fixed interest rates, often between 10% and 36%. The higher your credit score, the lower rate you can generally receive. Your monthly payment stays the same over the 1 to 7 year loan term.
You can use a personal loan for almost any purpose – debt consolidation, medical expenses, home improvements, major purchases, and more. The interest payments are not tax deductible.
What is a HELOC?
A home equity line of credit (HELOC) uses the available equity in your home as collateral. It works like a credit card, giving you access to a revolving line of credit up to a set limit.
Your home’s value and how much you still owe on your mortgage determine the maximum HELOC amount, typically up to 85% of your home’s value.
HELOCs have a draw period, often 10 years, where you can access the line of credit as needed. You only pay interest on the amount withdrawn.
After the draw period ends, HELOCs enter a repayment period with monthly principal and interest payments for 10-20 years to pay off the balance.
HELOCs have variable interest rates, currently averaging 5% to 8%. Your rate can fluctuate over time, which adds some risk.
If used for home improvements, the interest may be tax deductible. But if you default, you could lose your home.
Key Differences Between Personal Loans and HELOCs
There are several key ways that personal loans and HELOCs differ:
- Collateral – Personal loans are usually unsecured while HELOCs require your home as collateral
- Qualifications – HELOCs require home equity while personal loans weigh credit/income
- Loan amount – HELOCs offer higher limits, often up to $100,000+
- Interest rates – HELOCs have lower, variable rates while personal loans have higher, fixed rates
- Repayment terms – HELOCs have flexible draw periods while personal loans have fixed monthly payments
- Fees – HELOCs can have upfront closing costs while personal loans may have origination fees
- Tax benefits – HELOC interest can sometimes be tax deductible, personal loan interest cannot
- Risk – Defaulting on a HELOC could lead to foreclosure
So which option should you choose? Here are some key factors to consider:
How Much Money Do You Need?
If you need a small loan under $15,000, a personal loan is likely the better option. HELOCs often have higher minimum loan amounts.
But if you need over $50,000 for major home renovations or debt consolidation, a HELOC may be your only viable choice. The larger borrowing power makes it preferable.
How Will You Use the Funds?
The purpose of the loan can help determine which option makes more sense.
Since the HELOC interest can sometimes be tax deductible, it often makes the most sense for home improvement projects. Personal loans offer more flexibility for other uses.
How Long Will You Need Access to the Funds?
For one-time expenses, a personal loan is the simpler approach. The fixed monthly payments provide predictability.
But if you need ongoing access to credit for unfinished projects or recurrent expenses, the revolving credit line of a HELOC offers more flexibility.
Just keep in mind the draw period does eventually end and repayment begins. So don’t use it as an endless resource.
What is Your Credit Score and Income?
To qualify for a HELOC, you’ll need equity in your home. If you have little or negative equity, it won’t be an option.
With a personal loan, lenders look more closely at your credit score and income level to approve your application and determine your interest rate.
Those with excellent credit have the best shot at qualifying for a low personal loan rate. If your credit is poor, you may only qualify for a high-rate HELOC.
Do You Want to Risk Your Home?
Defaulting on a HELOC could put your home at risk. With an unsecured personal loan, your home is safe even in default.
If you don’t want to risk foreclosure, a personal loan is likely the safer choice.
Personal Loan Pros:
- Fast approval with good credit
- Fixed monthly payments
- Lower risk – your home is not collateral
- Funds can be used for any purpose
- Interest rate won’t fluctuate
Personal Loan Cons:
- Loan amounts up to $100k maximum
- Repayment period no longer than 7 years
- Rates often higher than HELOCs
- Upfront origination fees on some loans
- No tax benefits for interest paid
HELOC Pros:
- High credit limits, often up to $200k+
- Lower variable interest rates
- Interest may be tax deductible
- Draw period offers flexible access to funds
- Only pay interest on amount withdrawn
HELOC Cons:
- Need equity in your home to qualify
- Risk of foreclosure if default
- Rates can rise over time
- Upfront closing costs
- Repayment period eventually begins
Alternatives to Consider
If you need access to credit but aren’t sure a personal loan or HELOC is right for you, here are a couple alternatives worth considering:
- Balance transfer credit card – Transfer high-interest debt to a card with a 0% intro APR for 12-18 months
- Cash-out mortgage refinance – Tap equity with lower rate, but larger mortgage payment
Which Option is Right for You?
There are clear tradeoffs between personal loans and HELOCs to weigh based on your financial situation and goals.
As you make your decision, be sure to compare multiple lenders to find the best rates and terms. Pre-qualify to check rates without affecting your credit. Consider consulting a financial advisor if you need help deciding.
While HELOCs traditionally have had lower interest rates, some lenders now offer personal loans with rates as low as 5% for those with excellent credit. So make sure to shop around and crunch the numbers carefully.
The better option comes down to the amount you need, planned use of funds, your credit and income, risk tolerance, and repayment preferences. Do your homework to select the loan with the most favorable terms and lowest cost for your situation.
How home equity loans work
Home equity loans can be larger than personal loans because they use your home’s equity — the value of your home minus what you owe — to determine how much you can borrow. Most lenders will let you borrow up to 85 percent of your home’s combined loan-to-value ratio.
A home equity loan has one big advantage over a personal loan: lower interest rates. But because the loan uses your home as collateral, the lender has built-in recourse if you default on payments — specifically it can foreclose your home.
Unlike with a personal loan, the application process for a home equity loan is a bit more involved. While you can often apply online, the process usually takes a few weeks, since an evaluation of your property must take place. You can look into options from the lender that holds your mortgage and compare other home equity loans to understand how much you can borrow and what you might pay.
- Longer terms: Home equity loans come with terms of up to 30 years, giving you a more affordable monthly payment on larger loans.
- Larger loans: Home equity loan amounts are tied to the equity you have in your home. You may be able to borrow well over $100,000, depending on your equity and finances.
- Potential tax benefits: The interest paid on the loan may be deductible at tax time if the funds are used to make qualifying home improvements or repairs.
- Risk of losing your home: The lender could foreclose your home if you’re unable to make payments.
- Risk of owing more than the home is worth: If the market drops and your home loses value, you may end up owing more than what the house is worth, making it difficult to sell your home.
- Equity requirements: Most lenders require you to have at least 15 to 20 percent equity in your home to qualify for a home equity loan.
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- Personal loans and home equity loans can provide a much-needed source of funding if you need cash.
- Personal loans are less risky as they’re unsecured, but they often come with higher interest rates.
- Home equity loans are more accessible to borrowers with lower credit scores, but you could lose your home if you fall behind on payments.
- You may have access to a higher loan amount with a home equity loan as it’s based on your ownership stake.
Personal loans and home equity loans can be used for
Another big difference is that personal loans are unsecured, while home equity loans are secured and use your home as collateral. Consequently, deciding which one is best for your financial situation can be challenging as they both come with significant benefits and drawbacks.
HELOCs vs Personal Loans
What is the difference between a HELOC and a personal loan?
A home equity line of credit, or HELOC, is secured by your home, while a personal loan is typically unsecured and lending is based largely on your credit and income. In this article, we’ll review the pros and cons of HELOCs and personal loans to help guide you through the decision-making process. Looking for a HELOC? Compare Options Now
Can I get a personal loan if I don’t have a HELOC?
Common uses include paying for emergency expenses, medical bills, large purchases and consolidating higher-rate debts. You can also get a personal loan for home improvements, and it may be the best option if you don’t have enough home equity for a HELOC or don’t want to use the equity in your home.
Should I get a home equity loan or a HELOC?
Keep in mind that a home equity loan is a lump-sum payment, so a home equity line of credit (HELOC) may be a better fit for situations (such as a lengthy home renovation project or starting a business venture) where a large amount of ongoing funding is required or money will be needed continually over a period of time.
Do personal loans have higher interest rates than HELOCs?
Because they’re unsecured loans, your eligibility, loan amount and interest rate will largely depend on your creditworthiness. But even for the most creditworthy applicants, personal loans tend to have higher interest rates than HELOCs. You can use a personal loan to pay for almost anything.