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Home equity loan vs. personal loan: Which is best for home improvement?

Yahoo Personal Finance· Getty Images
Updated 12 min read

When you need to borrow money for home improvements, two options are a home equity loan and a personal loan. Both types of loans are installment loans with fixed interest rates, but their approval process and repayment terms vary significantly.

This article will explain the differences between a home equity loan vs. personal loan to help you decide which is the best way to pay for home improvements.

Before we cover when to choose a home equity loan vs. a personal loan, let’s break down how each type of loan works.

Your home equity is the amount of your home that you actually own. When you pay your mortgage each month, part of each payment goes toward paying down your principal, so your home equity grows over time.

A home equity loan is an installment loan that lets you borrow against the equity of your home and uses your home as collateral. You’ll typically receive the money you borrow in a lump sum of cash and have a fixed interest rate and payment. That means your interest rate won’t change with market rates unless you refinance, and your payment won’t change from month to month.

Home equity loans, or HELs, are a type of second mortgage. As with your primary mortgage, if you fall behind on payments, your lender could foreclose on your home. However, because your home serves as collateral, there’s less risk to the lender. That’s why home equity loans often have lower interest rates than other types of financing, including personal loans.

You can typically borrow about 80% to 85% of your home equity using a HEL. To estimate how much you can borrow with a home equity loan:

  • Start with the value of your home.

  • Subtract the amount you owe on the mortgage, which gives you your home equity.

  • Multiply your home equity by 0.8 or 0.85.

For example, if you have a $200,000 home with a $150,000 mortgage, you have $50,000 of home equity. You could probably borrow 80% to 85% of your home equity, or $40,000 to $42,500.

While home equity loans are frequently used to pay for home improvement projects and remodels, you can use the money you borrow for any purpose. For example, some people use a home equity loan to consolidate credit card debt or to pay for medical expenses at a lower interest rate.

Personal loans work a bit differently than home equity loans. A personal loan is an installment loan where you borrow a lump sum at a fixed interest rate and repay it on a set monthly schedule. You can use a personal loan for home improvement projects or virtually any purpose.

The big difference between a personal loan vs. a home equity loan is that a personal loan is usually an unsecured loan, meaning it isn’t backed by collateral, whereas a home equity loan is secured by your home. If you don’t repay a personal loan, you’ll incur late fees and damage your credit. However, your home isn’t directly at risk because you didn’t use it to secure the loan.

Some lenders allow you to borrow up to $100,000 through a personal loan, though others cap the limit around $50,000. Most personal loans have repayment terms of two to five years, but you may be able to find lenders that offer terms of seven years or more.

As with a home loan, you can use a personal loan for home improvement or a number of other purposes, including paying off debt or funding a major expense.

A home equity loan is often a good choice because you can borrow at lower interest rates. However, not everyone can qualify for a home equity loan.

The criteria for getting a home equity loan are often more stringent than the requirements to get a primary mortgage. That’s because the claims of the first mortgage lender get priority over other liens if the loan goes into default. Many lenders require at least a 620 credit score, though many have higher minimums. If you don’t have a good credit score, your lender may require that you have a high income or low debt-to-income ratio.

Most lenders also require at least 15% to 20% home equity to approve you for a home equity loan. If you’re a new homeowner seeking to upgrade your property or your home’s value has dropped since you bought it, you may not have enough equity to qualify.

Pros

  • Your monthly payments will probably be lower. Home equity loans have repayment terms of up to 30 years, whereas you’ll typically have just five to seven years to pay off a personal loan. Spreading out your loan over a longer term will result in lower monthly payments, which can make a project with large expenses more affordable.

  • Home equity loans annual percentage rates (APRs) are usually lower than personal loan rates. The lower home equity loan rates reflect the fact that home equity loans pose less risk for lenders than unsecured personal loans because your house is collateral.

  • May allow you to borrow money in large amounts. If your property’s value has significantly appreciated since you bought it, a home equity loan could allow you to borrow a large sum of cash. For example, if you paid $200,000 for a house that’s now worth $300,000, you have a minimum of $100,000 in equity and could probably borrow at least $80,000.

  • The interest may be tax deductible. You may be able to deduct the interest you pay on a home equity loan. However, under the Tax Cuts and Jobs Act, you can only deduct the interest on a home equity loan if you’re using the money to buy, build, or substantially improve a primary residence or a main home for tax years 2018 through 2025. Always consult with a tax professional if you have questions about deductions.

Cons

  • Long approval process: When you apply for a home equity loan, you’ll go through a process similar to the original mortgage application. Your lender will consider your credit score, income and debt-to-income ratio. You also may need an appraisal to determine the value of the home. Overall, the application process takes two to six weeks on average.

  • Your home is at risk if you can’t afford payments. Because your home is the collateral for a home equity loan, your mortgage lender could pursue foreclosure if you default. Also, because you’re taking more debt against your home, you could wind up with negative equity if home values drop. Also, if you sell your home, you’ll need to pay off both the primary mortgage and the home equity loan.

  • Usually requires closing costs. You can expect to pay closing costs of 2% to 6% of your loan. On a $50,000 home equity loan, that amounts to $1,000 to $3,000 in fees. Though some lenders don’t charge closing costs, they frequently charge higher interest rates.

A personal loan can be a good option for borrowing money when you don’t qualify for a home equity loan or when you’re funding a relatively inexpensive project.

  • Available in smaller amounts. Many major banks only offer home equity loans of $10,000 or more. If you’re seeking a smaller amount of money for a minor project, a personal loan may better suit your financial needs because you’re only paying interest on money you need to borrow. That can be a drawback, though, if you’re planning a major project.

  • Doesn’t require home equity. When you apply for a personal loan, lenders will base their decision on your creditworthiness and income. If you’re a new homeowner who hasn’t built much equity or your home is worth less than it was when you bought it, a personal loan may still be an option.

  • You can get your money faster. The loan application process is a lot more streamlined for a personal loan vs. a home equity loan. Once you’re approved by your bank and credit union, you’ll typically have the loan funds in your bank account in one to five business days. Some online lenders even offer same-day funding. Because the funding is quick, a personal loan can be a good choice if you need to pay for an emergency home repair.

  • Higher interest rates. Because you aren’t using an asset as collateral, personal loans usually have higher interest rates than home equity loans. To qualify for the best personal loans with competitive interest rates, you’ll need a good to excellent credit score. Though some lenders offer personal loans for bad credit, the interest rates and fees can be exorbitant.

  • Possible origination fees. Some lenders charge upfront origination fees for personal loans that range from 1% to 8%, though if you have good credit, you may be able to avoid these fees. If you’re considering a personal loan, be sure to consider the overall borrowing costs, including your interest rate and fees.

  • Shorter repayment period: Most personal loans have a maximum repayment term of five to seven years, which is significantly shorter than you can get through a home equity loan. Your monthly payments will be higher due to the longer repayment term.

Home equity loans and personal loans aren’t the only ways to pay for a home project. Here are a few alternatives to consider.

A home equity line of credit (HELOC) is a revolving line of credit that you can use for major purchases, including home upgrades and repairs. As with a home equity loan, your home serves as collateral. One advantage of a HELOC is that you can draw on it as needed, as you would with a credit card, and only pay interest on money you use.

Credit cards typically have higher interest rates than both home equity loans and personal loans, but there are a couple of situations when you may want to consider using a credit card for home improvements.

Some of the best credit cards have a temporary 0% introductory period for anywhere from 12 to 21 months. If you’re confident you can pay off the balance before interest starts to accrue, using a credit card during the zero-interest window can save you money. Using a credit card to pay for home projects can also make sense when you’re trying to earn rewards. However, if you don’t pay your balance in full each month, the interest will typically cost more than the value of your rewards.

While a home equity loan is a type of second mortgage, a cash-out refinance is when you refinance your primary mortgage and receive part of your equity as a lump sum of cash. You can then use the equity for home projects or other large expenses. A cash-out refinance is also an option for homeowners who have paid off their mortgage and want to tap their equity.

Read more: Cash-out refinance vs. home equity loan

personal loans

The best way to pay for a home remodel or another major home project depends on your financial situation. But here are some general rules about when a home equity loan vs. personal loan is best.

Consider a home equity loan if:

  • You own at least 15%-20% of equity in your home.

  • You need to finance more than $50,000.

  • You’re not funding an emergency repair and can wait several weeks for the loan to process.

Consider a personal loan if:

  • The project you’re funding is relatively small.

  • You don’t have significant home equity.

  • Your home is in need of immediate repair.

Make sure you know your goals before you borrow money for a home project. It’s fine if you’re planning a project to make your residence a better place to live, so long as you can afford it.

But be cautious if your goal is to improve the resale value. Some projects, like a kitchen remodel or a swimming pool addition, typically don’t recoup their full costs at sale time. Others, like DIY projects and garage conversions can actually hurt the resale value.

Before you borrow money (and pay interest) to improve your home, make sure you’re likely to get the return on investment you’re seeking.

Whether you take out a loan or tap your home equity, you’re still borrowing from a bank or another financial institution. But with a home equity loan, your home serves as collateral. A home equity loan is often best when you want to pay lower interest rates and monthly payments. However, a personal loan can be a good choice if you don’t have at least 15% to 20% home equity or if you’re looking to fund a minor project.

A home equity loan can be a good option for debt consolidation, since the interest rates are typically lower than credit card and personal loan rates. To qualify, you’ll need good credit history and a decent amount of home equity.

You can use a personal loan for a wide variety of purposes, including home renovation, debt consolidation, a wedding or vacation, or medical expenses.

Your monthly payment would be $606.64 if you took out a 10-year fixed interest rate home equity loan at 8% APR. To estimate your monthly payment, it’s important to use a loan calculator and include the loan amount, annual percentage rate and loan terms. That $606 would be in addition to what you currently pay on your primary mortgage, so make sure you can afford that second mortgage payment.