Whether you’ve just moved into a new house or you’re spiffing up a long-term place, home improvements are not cheap.
The average kitchen remodel, for example, cost $19,993 in 2016, according to HomeAdvisor.com. Other parts of the home (like a bathroom or garage) cost about half that, but these expenses can add up—particularly if you’re remodeling an entire house. That’s a lot more than you want to put on a credit card.
Many homeowners overcome this challenge with a loan to cover remodeling costs and improving their home’s value—but how do you know whether a home equity loan or a home improvement personal loan is better for your situation? We’re here to help.
What’s the Difference Between a Home Equity Loan vs Personal Loan
Isn’t a loan… a loan? At its most basic, yes. But there are nuances that distinguish the two types of loan options.
What is a home equity loan?
A home equity loan, or second mortgage, leverages the money you’ve already paid towards your house—your home equity—as a guarantee to the lender that you’ll repay the loan offer. This is a type of secured loan, in this case, secured by your house, which the lender can seize should you fail to make your payments. Typically borrow up to 85% of their equity, and the loan is made for a fixed amount of money, in a lump sum.
Home equity loan terms tend to be around 15 years, but can range from five to 30 years. Rates for these loans currently hover around 5%, the average rate being 5.21% in early 2017. A home equity loan has similar interest rates as but is distinct from a home equity line of credit (commonly known as HELOC), which acts as a revolving line of credit rather than a one-time installment.
What is a home improvement personal loan?
A home improvement personal loan, on the other hand, is an unsecured loan, so the lender takes on additional risk. As such, personal loans have higher interest rates than those for home equity loans depending on your credit score — Earnest offers home improvement personal loans starting at 5.25%. A higher interest rate means you will make larger interest payments over the life of the loan.
These loans are personal loans applied toward home improvements, and repayment terms are therefore shorter—generally a few years at the most. If you don’t make your loan payments in the repayment period, the lender can send your account to collections (which will be marked in your credit history), but does not have the right to seize your house or other assets.
How are home equity loans and personal loans similar?
Both a home equity loan and a home improvement personal loan function similarly once you’re approved—you’ll receive the loan amount, make monthly payments to the lender, interest will accrue as time passes, and the rate you’re given when you apply stays the same, as they’re both fixed-rate loans. And you can use the funds to improve the market value of your home.
When a Personal Loan Makes More Sense
There are a number of factors that can make a personal loan a better option than a home equity loan for your financial situation.
Securing a personal loan is easier and faster
First, personal loans are generally easier and faster to get. Applying for a home equity loan requires a lot of paperwork as it’s similar to a mortgage—in fact, you’d better start gathering your past two years of financial documents if this type of loan is your first choice.
Most personal loans, on the other hand, will require only basic documentation to verify your identity and income. In addition, personal loan applicants typically receive a loan decision within days, as opposed to weeks. While the application process is not as fast as swiping a card, a personal loan helps you avoid the high fees and higher interest rates associated with credit card debt. For borrowers on a tight timeline looking to make home renovations, a personal loan can be the perfect solution.
Personal loans don’t require equity in your home
Second, for those who bought a house recently and just paid closing costs, a personal loan may be your only option. As the name suggests, a home equity loan requires you to not just have good credit, but have equity in your home—which you won’t have until you’ve been paying your mortgage for some time. In pre-financial crisis days, home equity loans were given out readily based on your home’s value, but it doesn’t look like these practices will be coming back any time soon—80% of home equity lenders did not report any changes in their underwriting criteria in 2016, meaning your chances of qualifying for home equity loan or home equity lines of credit without having paid a significant chunk of your mortgage are slim.
If you were planning to use your home equity for another expense
Lastly, a personal loan might be a better choice if you were planning to tap your home equity for something else. Some families rely on their home’s value to help pay for college education, while others might use a home equity loan to start a business or cover other liabilities. If this is the case, a personal loan could allow you to both make the necessary home improvements and leverage your home’s equity for another purpose.
When a Home Equity Loan Makes More Sense
Home equity loans can be a good option for home improvements that will require between $25,000 and $60,000, as lenders typically won’t give you much more than that for an unsecured personal loan. If you’ve paid off a good amount of your mortgage and excellent credit, however, you may be able to get a home equity loan for a larger amount of money.
In addition, secured loans tend to come with lower interest rates, and home equity loans typically hold a longer loan term than personal loans—translating to lower monthly payments. If you have significant equity in your home as well as the time and patience to wait for your application to be approved and the money delivered, a home equity loan may be a less expensive option over the life of the loan.
As with any loan, it’s always worth shopping around to compare your options—and in this case, it might be worth comparing not only within, but also across, loan types.