Personal loans vs. home equity loans: Which should you choose?

Personal loans explained

Personal loans are unsecured loans that you can use for almost any purpose. They offer fast cash without requiring an appraisal, collateral or strict underwriting requirements. Loan applications are often submitted online or over the phone with quick approvals for eligible borrowers.

These loans are repaid over a shorter term than home equity loans (typically three to seven years) and carry higher interest rates because they aren’t backed by any assets.

In many cases, you can make extra payments or repay the loan early without any penalties. However, some lenders charge origination fees, which are deducted from your loan proceeds.

Key points about personal loans

• Use of proceeds: Personal loans can be used for almost any purpose, such as emergencies, debt consolidation, vacations or home improvements.
• Common borrower profile: Borrowers typically have strong credit scores but don’t have assets or equity in their home (or don’t want to use their assets/equity as collateral).
• Loan amounts: These range from $1,000 to $100,000, but many lenders max out at $50,000.
• Terms: Most personal loan terms range from three to seven years, but this varies by lender.
• Credit score: Credit score requirements also vary by lender, but some lenders accept scores of 600 or lower. Upstart accepts credit scores as low as 300.
• Interest rate: Interest rates vary based on your credit score, loan term and the amount you borrow. Rates generally range from around 8% to 36% as of publication.
• Approval time: Some lenders offer immediate decisions, while others may take a few days to review application details manually.

» COMPARE: Best personal loan companies

Pros and cons of personal loans

Personal loans offer fast approval and flexibility but come with relatively high interest rates and lower loan amounts than home equity loans. Before applying for a personal loan, consider the pros and cons of this loan type.

» MORE: How does a personal loan affect your credit score?

Home equity loans explained

A home equity loan is a second mortgage that allows you to borrow from your home's equity. Because home equity loans are secured by your home, they usually offer attractive interest rates.

Since they are based on the value of your home, most home equity loans require an appraisal. The appraised value determines the maximum amount you can borrow after factoring in the balance of your primary mortgage. Many homeowners choose home equity loans as a way to tap into their home's equity without refinancing their primary mortgage.

Keep in mind that home values are impacted by market forces and the general state of the economy. Some lenders stop accepting home equity loan applications when they believe that home values are at their peak and/or an economic downturn is imminent.

Key points about home equity loans

• Use of proceeds: Home equity loans are often used for home improvements, debt consolidation and other large expenses. Under current tax law, home equity loan interest is deductible only when used to buy, build or improve your home.
• Common borrower profile: Home equity loans are available to borrowers who have at least 15% to 20% equity in their homes.
• Loan amounts: Loan amounts depend on how much home equity you have and your lender's maximum loan-to-value (LTV) ratio. Most lenders allow 80% to 85% LTV.
• Terms: Most home equity loan terms are either 10 or 15 years, though some lenders may offer home equity loans with terms as short as five years and as long as 30 years.
• Credit score: Lenders typically require credit scores of at least 620.
• Interest rates: Interest rates are fixed and vary by lender. Your rate will be based on your LTV, credit score and other factors.
• Approval time: Your application can be approved within a few days, but underwriting and funding can take a few weeks.

» COMPARE: Best home equity loan lenders

Pros and cons of home equity loans

While home equity loans typically accept lower credit scores while granting you access to higher amounts of money than personal loans, they come with their own risks. Your lender could foreclose on your home if you miss too many home equity loan payments, and an outstanding home equity loan balance can complicate the process of selling a home.

Karl Jacob, CEO of mortgage lender LoanSnap, explained that a home equity loan "is a lien on your home, so you have to pay off the home equity loan as part of the process of refinancing or selling the house."

» MORE: How to stop foreclosure

Comparing personal loans and home equity loans

Personal loans and home equity loans have many similarities, but they also differ in important ways. Compare them carefully when deciding which loan type is best for your borrowing needs.

What personal loans and home equity loans have in common

These loan types have several features in common that make them popular choices for borrowers:

• They typically have fixed interest rates throughout the loan term.
• Their monthly payment amounts generally don't change.
• Their funds can be used for a wide range of purposes.

How personal loans and home equity loans differ

Personal loans and home equity loans diverge in a number of ways:

• Personal loans are unsecured, while home equity loans are secured by your home.
• Home equity loan interest may be tax deductible, depending on how the money is used, while personal loan interest isn’t tax deductible.
• Personal loans can be approved and funded within one business day, while it can take weeks for a home equity loan to be finalized.
• Interest rates for home equity loans tend to be lower because they are secured by your home, whereas personal loan interest rates are higher because they're unsecured.

Alternatives to personal loans and home equity loans

Personal loans and home equity loans aren't the only ways to borrow money. Other financing options may be a better fit depending on your credit score, borrowing needs and the expected time frame to repay the debt.

Credit card intro APR offers

Credit cards generally have high interest rates, but many offer 0% introductory annual percentage rates (APRs) for new accounts. These offers on balance transfers, new purchases or both allow you to avoid interest during the promotional period. Applications are often approved the same day, so you can start spending almost immediately.

Just be sure to pay your balance off before the promotion expires to avoid paying interest at the card’s regular rates.

Home equity line of credit

A home equity line of credit (HELOC) is similar to a home equity loan, as it is secured by your home's value. However, a HELOC differs from a home equity loan in that it is a revolving line of credit rather than an installment loan. You can repeatedly withdraw and repay funds from a HELOC as you would with a credit card.

A HELOC’s draw period may last for up to 10 years, and you can make interest-only payments on any funds borrowed from the HELOC during that time. Any outstanding balance following that period is amortized into principal and interest payments during the subsequent repayment period. Note that a HELOC’s interest rates are usually variable during the draw period, which can be a disadvantage in rising rate environments.

401(k) loan

Borrowing from your company’s retirement plan offers guaranteed financing because there aren't any underwriting criteria. In accordance with federal law, companies typically let workers borrow the lesser of up to 50% of their 401(k)’s value or $50,000. If you have a 401(k) loan balance, your paycheck’s usual 401(k) contributions may go toward paying down that balance rather than being invested.

A major downside of a 401(k) loan is that the loan balance may be due immediately if you leave your job. If you don't repay it, the loan is considered a disbursement. This leads to a 10% penalty, and the balance counts as taxable income.

Bottom line

The choice between personal loans and home equity loans is a personal decision, based on your reasons for borrowing, the amount of money you need and the amount of risk you’re willing to take on.

Personal loans are unsecured and offer quick approval and funding. Home equity loans provide lower interest rates, but they're secured by your home, and the approval process can take weeks.

Before applying for either type of loan, consider your alternatives to ensure that you're choosing the best loan for your financial needs.