Home loan vs personal loan: make the right choice

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When choosing a solution to a cash flow problem, home equity and personal loans can do the trick. But your situation will determine what works best in your situation.

  1. Home equity loans and lines of credit (HELOC) have lower rates, but require home equity
  2. Personal loans are generally faster to obtain, have lower setup costs and shorter terms
  3. Personal loans are unsecured and most require great credit

In general, personal loans are great for small amounts that you pay off quickly. The terms of home equity loans can be extended for several years. Of course, you pay more interest in total when your payment is extended.

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Consider all the options

Don’t ignore the other contenders in the loan battle. For example, a credit card with balance transfer can give you the relief you need from smaller amounts. Or a peer-to-peer loan could meet a need of up to, say, $ 40,000. And a Home Equity Line of Credit (HELOC) offers different advantages and disadvantages compared to its home equity loan sibling.

Related: Home Equity Loan vs Line of Credit (HELOC)

You need to compare as many options as you can find.

What are Home Equity Loans and Personal Loans?

Both are installment loans. In other words, you borrow a fixed amount for a fixed period and make fixed or variable payments each month.

The main difference is that personal loans, also known as signature loans or unsecured loans, are not secured by your home. The personal lender cannot foreclose on your home. But a mortgage lender can. For this reason, loans secured by your home have lower interest rates – the lender has more protection.

Related: How Does a Home Equity Loan Work?

Personal loans can have fixed or variable interest rates. When rates are variable, if the Federal Reserve increases general rates, your payments are likely to increase based on its changes. Home equity loans can also be fixed or adjustable. Most home equity loans have fixed rates. Most home equity lines of credit have variable rates.

Whichever you choose, you should research the prepayment penalties, which some – but far from all – lenders impose. These come into play if you want to fill out an application form to write off your loan sooner. Of course, it doesn’t matter if you are sure that you will want the loan to run for its entire term. But you should check your loan agreement for them and only proceed if you are comfortable with their potential costs.

Some key differences

When choosing which of these loans is best for you, it’s the differences rather than the similarities that matter. Here are some of the main ones.

Duration, size and prices

You can find exceptions, but personal loans usually last between one and five years. HELs can have terms of five to 30 years.

Personal loans also tend to have higher interest rates than HELs. At the time of writing, a national lender quotes rates for the former in a range of 7.24% to 24.24%. Depending on the rates in effect at the time of your application and your personal circumstances, you could get an HEL for about 5 percent. However, you must be an attractive borrower to qualify for this rate.

You don’t have to be a math genius to figure out that a shorter term and a higher rate are going to make the monthly payments on a personal loan much higher than on an HEL. This is why few people borrow more than $ 100,000 with a personal loan.

On the other hand, extending your repayment to 30 years instead of, say, five years will almost certainly cause you to pay more total interest, even if the interest rate is significantly lower.

Secure vs unsecured

Home equity loans are “secured”. You make your home safe. So if you fail to keep your end of the bargain, your lender can quickly foreclose on your home. This most often happens when a borrower cannot maintain their monthly payments.

Personal loans (sometimes called signature loans) are “unsecured” which means that you do not put a particular asset as collateral. Of course, lenders will always sue you if you fail to keep the payments. And, in the end, they might even be able to put you out of business. But they don’t have a direct legal route to foreclose on your home if you get into trouble.

This is an important point. No one should lightly endanger their home.

Time and costs of setting up the loan

A HEL is a second mortgage. And with it comes pretty much all of the time-consuming administrative baggage you encountered when setting up your first mortgage. It also results in equally high closing costs, including appraisal, title search and document preparation costs.

Some lenders offer HELs with no closing costs. However, it may be that these costs are simply masked by a higher interest rate. Of those who charge them, most will allow you to incorporate them into your new loan. Either way, you need to keep an eye on your total cost of borrowing when comparing offers.

Home equity lines of credit usually come with low or no setup fees. But their interest rates are variable and there are often prepayment penalties.

Personal loans are generally much faster and cheaper than HELs to set up. Indeed, some lenders do not charge any setup fees. The ones that typically charge a small fraction of what you would pay in closing costs on an HEL. It is possible to get a personal loan approved in a week or even days, although very large sums may take longer.

Home loan vs personal loan: eligible for everyone

For both of these loans, the lenders will want to make sure that you are creditworthy and that you can easily afford the payments. If you borrow a large amount, they’ll expect your credit rating to be in the good to great range. And they’ll want you to prove that you can easily cover the costs of your family budget.

And they will likely be more stringent when it comes to the credit scores and household finances of personal loan applicants. This is because they don’t have the comfort of knowing that they can quickly grab a house if things go wrong.

Lenders may be concerned if a large portion of your income is going to service other debt, including your current mortgage, is high. You may be able to allay their fears if you use some or all of your new loans to pay off other debts. If so, these creditors will likely be paid directly by the title company at closing.

Home equity loans: another hurdle

The “equity” of the “home equity loan” refers to the equity in your property. It is the amount by which the current market value of your home exceeds your current mortgage balance. For example:

  • Current market value of your home: $ 200,000
  • Amount you owe on your mortgage (its balance) today: $ 120,000
  • Your equity: $ 80,000

Unfortunately, that doesn’t mean you’re going to be able to borrow all that $ 80,000. Lenders will want you to keep some equity in your home. Many insist that your total borrowing is no more than 80% of your home’s value, although some may extend it to around 90%. In industry parlance, you need a loan to value ratio (LTV) of 80% or 90%.

LTV example

Let’s continue with the same example:

  • Current market value of your home: $ 200,000
  • 80% LTV: 160,000 USD
  • Less your current mortgage balance: $ 120,000
  • Amount available for a home equity loan: $ 40,000

If you find a lender willing to go for a 90% LTV, you will be able to borrow $ 60,000. This 90% LTV would cap your loan at $ 180,000 (90% of $ 200,000) and you must deduct your current mortgage of $ 120,000.

All other things being equal, the lower your LTV, the lower your interest rate will be.

Home loan vs personal loan: 3 questions

When choosing your winner in the home loan vs personal loan competition, three questions are likely to guide you to a better choice.

1. How much should I borrow?

The larger your loan, the more likely you will need lower monthly payments. However, you may be limited by the amount of equity in your home.

Meanwhile, an HEL rarely makes sense for smaller sums, simply because it costs so much to create one.

2. What is the cost of each option?

You need to calculate the total cost of borrowing for each transaction you are considering. This applies to all personal and HEL loan offers you receive. And you always get at least three quotes for all of your loans. Is not it?

You need to know how much your loan will have cost you in interest and setup fees (origination fees or closing costs, if applicable) when you finally make your last payment. It is essential that you know this dollar amount.

Of course, you don’t have to go for the lowest cost. There may be good reasons why you are choosing the lower monthly payments of an HEL rather than a cheaper personal loan. Which leads to …

3. What payment can I afford?

If you can afford the higher monthly payments on a personal loan, you will certainly be better off in the long run by choosing this route. While you will likely pay a higher rate and make larger payments, you will be borrowing for a much shorter period. And that makes a bigger difference to your total cost of borrowing than interest rates in all but the most exceptional circumstances.

Generally, a personal loan also has the advantage of ending more quickly. You will be released from the burden sooner. This is especially important if you are using your loan to consolidate existing debt, such as credit card balances. Do you really want to pay for the shoes you bought last month and the restaurant bill you billed last week in 15 years?

But, more importantly, you need to be sure that you can comfortably cover your payments, no matter what type of loan you choose. Stretching your budget too far can lead to stress levels – and ultimately dire consequences – that just aren’t worth the savings you can make by making the supposedly “smart” choice.

Check your new rate (May 19, 2021)

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