When you need to borrow money, should you apply for a personal loan versus a home equity loan, or a line of credit? The answer for homeowners depends on your income, credit history, the amount of equity in your home, and how you plan to use the funds.
Understanding Personal Loans
A personal loan is typically money you borrow in a lump sum from a lender and pay back in fixed monthly amounts, usually over the course of several years. Borrowers use the money for a variety of financial needs.
Personal loan interest rates are typically higher than those for a home equity loan, but personal loans usually don’t require collateral and are approved more quickly.
When to Choose a Personal Loan
A personal loan makes sense when the alternative is using a credit card with a higher interest rate.
“Personal loans should be reserved for big-ticket purchases, when paying over time with interest is palatable. A home improvement project that adds value to your home would be a good use of a personal loan,” says Jackie Boies, senior director of housing and bankruptcy services at Money Management International.
It’s also a smart option when you don’t have a great deal of equity in your home since equity plays a significant role in how much (and whether) you can borrow with a home equity loan.
Understanding Home Equity Loans
A home equity loan (also referred to as a second mortgage) leverages the equity built up in your property. That equity serves as collateral for the loan and influences how much you can borrow, along with your credit history and income. Interest rates are typically lower than with personal loans, but the application and approval process takes longer because it requires a property evaluation.
As with personal loans, you receive the money in a lump sum and make fixed monthly payments to the lender. While a personal loan is usually paid back in two to seven years, a home equity loan can extend to 15 years. Because the interest rate is sometimes lower than for a personal loan and the repayment period is longer, the monthly payment amount is typically lower, too.
When to Choose a Home Equity Loan
Lenders generally require a borrower to have at least 15% to 20% equity in their home to qualify for a home equity loan, which means it’s not an option for all homeowners. How you plan to use the money makes a difference in whether it makes sense for you as well.
“If you use home equity to pay for consumer goods or a vacation, your net worth decreases. But using it for home improvements may allow you to increase your home’s value, claim a tax deduction for a certain amount of loan interest, and increase your net worth,” says Laura Adams, personal finance site Finder.com’s real estate expert.
Line of Credit Options
A home equity line of credit (HELOC) and a reverse mortgage line of credit are additional options that work differently from personal and home equity loans. Both a HELOC and a reverse mortgage line of credit are secured by your home and a lender can foreclose if you default on the terms of your loan. However, both have key differences with various implications.
Home Equity Line of Credit (HELOC)
If you have an existing mortgage, a HELOC will be a second mortgage. The amount you can borrow is determined by the value of the home. With a line of credit, you borrow from funds available on an as-needed basis. Many homeowners open a line of credit in case they need money for an emergency or unexpected expense.
Once you’ve borrowed against it, a HELOC requires that you make monthly payments. For many, it’s a just-in-case safety net because you can potentially pay off the balance with other assets. You aren’t required to live in your primary residence and HELOCs can be used to fund investment properties and second homes. Like a home equity loan, a HELOC usually offers a lower interest rate than a personal loan.
Reverse Mortgage Line of Credit
A reverse mortgage line of credit is available only to reverse mortgage borrowers. The age of the borrower must be 62 years or older.
Your financial situation will determine which borrowing options are the best fit for you and your needs. It’s always wise to seek counseling from a financial professional when weighing your options.
One of the key benefits of a reverse mortgage line of credit is that there isn’t a monthly mortgage payment requirement and borrowers aren’t required to take the full amount of proceeds available to them at closing. It affords the option of borrowing in phases. Unlike a HELOC, there can be no other existing liens on the home (they can be paid off with the reverse mortgage proceeds at closing), and borrowers are required to live in the home as their primary residence most of the year.
This article is intended for general informational and educational purposes only, and should not be construed as financial or tax advice. For more information about whether a reverse mortgage may be right for you, you should consult an independent financial advisor. For tax advice, please consult a tax professional.