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What is the difference between a home equity loan and a personal loan?

What is the difference between a home equity loan and a personal loan?

Your home is not only a shelter but may also be your most significant financial asset, with a value that may increase over time. A home equity loan can allow you to borrow against the property's value when you need to access a large amount of money. In contrast, you can get a personal loan when you need a smaller amount or wish to borrow money for a shorter period of time.

What is the difference between a home equity loan and a personal loan?

Home equity loan

Equity is a home's current value minus the amount you owe on your home loan. Home equity loans allow the homeowner to borrow money against their home's equity. Home equity loans typically have lower interest rates and longer repayment terms than personal loans, but one needs sufficient equity to use as collateral when borrowing.

Lenders have different policies on how much one can borrow on the basis of home equity. However, most lenders have a policy of retaining at least 20% of the property value as security and allowing you to borrow up to 80% of the property value minus the remaiing mortgage principal - this is your usable equity.

A new home-owner might not yet have enough equity available on to borrow money with a home equity loan. Your eligibility for a home equity loan will depend on how speedily you can pay off the mortgage and how much the value of the home increases over time. 

Personal loan

Various banks and online lenders offer personal loans, based on the borrower’s finances and creditworthiness. Borrowers with excellent credit scores are more likely to be quickly approved for personal loans with lower interest rates. A borrower may be eligible for a loan of up to $100,000 if their credit score is strong and they have a relatively low debt to income ratio. 

Personal loans are offered by various banks, online lenders, and credit unions. Personal loans can be used for a variety of different purposes, such as consolidating other debts, travelling, paying for a wedding or education. 

Home equity loan vs personal loan - which one is the best pick?

One of the privileges of homeownership is that you can grow equity in the property each time you make a principal & interest mortgage payment. You can build wealth over the years, to potentially access in the future through a home equity loan. 

You can apply for a personal loan from a bank or other lender any time you wish. If you have a good credit score, low debt, and good flow of income, the lender may agree to lend you the amount you need.

Home equity loans tend to offer lower interest rates compared to personal loans because the lender uses the home as security. Of course, this means there's a risk of losing your house if you default on your repayments in the future.

The home equity loan application process can be a bit more time-consuming than is usually the case for a personal loan. The process might take several weeks as the lender will need to undertake a property valuation to confirm your usable equity amount. 

Why choose a home equity loan?

  • You want to take a loan at low rates. 
  • You have built up a good amount of equity, and want to borrow more money.
  • You want to consolidate a high level of debt.

When should you choose a personal loan?

  • You wish to borrow a smaller amount
  • You want the loan for a shorter time.
  • You don’t want to put up your home as security because you do not want to risk losing the property if you default.
  • You don’t qualify for a home equity loan.
  • You have a good credit history and are eligible for the lowest personal loan rates. 

A home equity loan can be a great choice when you need a significant amount for home renovations, paying off a large amount of debt, purchasing another property, etc. On the other hand, a personal loan may be helpful if you need money for a short period or a few thousand dollar, with relatively hassle-free processes.

If you don't have home equity available, you might consider taking out a personal loan. Before you do, you may want to make sure you have an excellent credit score and good cash flow in order to pay back the loan. 

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This article was reviewed by Personal Finance Editor Mark Bristow before it was published as part of RateCity's Fact Check process.

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