In early 2023, consumers have found themselves caught in the midst of an economy that is flashing different signs. On the one hand, the labor market is extremely strong, with unemployment at its lowest figure in years and employees earning higher wages. On the other hand, inflation is at its highest level in decades, and the Fed has been aggressively increasing interest rates to counter it. That translates into higher costs for consumers on everything from personal loans and credit cards to home mortgages and auto loans.
If you find yourself in need of some additional funds to help make ends meet, two of the most common sources are personal loans and home equity loans. But depending on your situation, one of these two options could make much more sense – while choosing the wrong one could cost you in unnecessary interest charges. Here’s a look at the pros and cons of using home equity vs. personal loans for funding your financial needs.
Home Equity Loan
A home equity loan is a solid way to use what’s effectively your own money to provide for your current needs. Although technically a home equity loan is a standard loan made with a third-party lender, the equity in your home is used as collateral. While you will pay interest on your loan, you’re essentially pulling some of the value of your house – which you own – to put cash into your bank account. Some people prefer this method of financing rather than taking out a brand new loan with no collateral backing it.
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Home equity loans come with a number of other advantages as well. For starters, you’ll likely find it easier to qualify for a home equity loan because you’re using a large asset as collateral. In many cases, you’ll also qualify for a lower interest rate, since your loan will be backed by a tangible asset rather than just your unsecured promise that you will pay the loan back.Â
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There are some things to watch out for if you take out a home equity loan, however.Â
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The first is that you’ll have to pay for an appraisal so that your lender can figure out how much you can borrow. That alone could cost you hundreds of dollars. To qualify for a home equity loan, you’ll need to maintain at least 80% equity. That means if you own a $400,000 home, the combination of your mortgage and your new home equity loan could not exceed $320,000.Â
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The follow-up problem to the home equity situation is that if home prices drop, you might end up in a position where you are underwater. Imagine that you own that $400,000 home with $320,000 of debt against it and home prices fall 25%. At that point, your home will only be worth $300,000, but you’ll owe $320,000 on it. In most cases, a 20% equity cushion is more than enough to protect you from this. However, it is one of the risks you’ll have to consider if you go this route.
Personal Loan
Personal loans don’t require any collateral. You can also typically apply for a personal loan online and get funded in as little as 24 hours, all with no fees. These factors are just some of the huge advantages that personal loans have over home equity loans.Â
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With no collateral, you won’t have to worry about losing any assets if you end up being unable to make payments. Whereas with a home equity loan you might lose your house to your lender, with a personal loan, there’s nothing direct for a lender to attach in the event of default. If you have extensive other assets then yes, you may have to liquidate those to cover your personal loan. But your home will not be one of them, as it is generally protected by creditor laws.Â
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One of the downsides of taking out an unsecured loan like a personal loan is that with no collateral, you’ll likely pay a higher interest rate. This may vary based on your credit score, but you should anticipate paying a higher rate than with a secured loan like a home equity loan.Â
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Personal loans also generally have higher monthly payments than home equity loans. However, that is because most personal loans have maturities of between one and 10 years. A home equity loan, on the other hand, might have a 30-year payback period. This results in higher monthly payments for a personal loan but lower interest costs over the life of the loan.
The Bottom Line
Choosing between a home equity loan vs. a personal loan involves a lot of financial analysis. Both are financial commitments that you don’t want to make without fully understanding the ins and outs of how they operate. This is why it’s a great idea to work with a certified loan specialist who can provide you with the pros and cons of every type of loan for your personal financial situation. Only with all of the information in front of you can you make a prudent decision about which type of loan best suits your needs.
About the Author
David Halverson
With over 10 years of direct experience in the lending space, Lendzi’s leaders have established over 60 partnerships with top lending institutions and have overseen an excess of $500 million raised for entrepreneurs across America.