If you need cash for major or minor expenses, you might consider personal loans vs home equity loans. Each has pros and cons, and one is probably better for you than the other.
Personal loans vs home equity loans
If you face an upcoming medical expense, a surprise tax bill, or a roof replacement — the big question is probably what’s the best way to finance it. Some of the options to consider include cash from savings, a home equity loan or a personal loan.
The quickest and easiest approach is to write a check, but often we don’t have the ready cash or we don’t want to hit our emergency fund. Realistically, for many households the real choice is between a home equity loan or a personal loan.
How does a home equity loan work?
A home equity loan is a mortgage. A mortgage is financing secured by your personal residence. The value of your property minus any existing liens determines how much you’ll be able to borrow.
If you have a home worth $350,000 and your current mortgage has a $100,000 balance, then in rough terms you have $250,000 in equity. If a lender will allow a combined loan-to-value ratio (CLTV) of 90%, it means you can get a home equity loan for as much as $215,000 ($350,000 x 90% = $315,000. $315,000 less $100,000 = $215,000).
Once you have a general idea of how much you can borrow — and remember that different lenders will allow different combined loan-to-value ratios — you can choose from two types of loans. They are the fixed home equity loan and the HELOC.
Fixed home equity loan
One choice is a simple fixed home equity loan (sometimes called a second mortgage). Typically, it’s a fixed-rate mortgage with a specific term, say 10 or 15 years. The interest rate is slightly higher than that of a first mortgage because it’s a little riskier to the lender. Second mortgages also come with lender fees, title and escrow charges and may require a home appraisal.
If you borrow $50,000 over 15 years at 5.25%, the monthly cost for principal and interest is $402. The lender releases the $50,000 lump sum to you at closing.
Home equity line of credit (HELOC)
Another way to access real estate equity is with a home equity line of credit (HELOC). In this case, the lender creates what is essentially a giant credit card.
A typical HELOC is an adjustable-rate mortgage with a term ranging from five to 30 years. The loan has two phases — a drawing phase and a repayment phase.
With a 15-year loan, you may have a 5-year drawing phase, in which you can take out money up to the credit limit and you make payments to cover your interest cost and reduce your balance. Once the drawing phase ends, you can no longer tap your credit line. The lender calculates your payment from the amount of time remaining in the repayment phase and your interest rate, which may change over time.
Because you now have just ten years to repay your balance, your payments may shoot up if you have a significant outstanding balance at the end of the draw phase. At a 5.25% rate, the interest-only minimum payment during the drawing phase for a $50,000 balance would be $218.75. But if you enter the repayment phase owing $50,000, your payment spikes to $536.46.
Pros and cons of home equity loans
Home equity loans usually have lower interest rates and payments because they are safer for lenders. And a fixed-rate loan can make budgeting easier. While a home equity loan can be attractive, it can have a number of drawbacks.
The first, of course, is that a property might have insufficient equity to qualify for financing. Because the loan is secured by the property, the financing must be recorded in local property records. That means a formal settlement and an assortment fees and taxes. Such closing costs can be expensive, especially if you expect to sell the home in the near future.
When is a home equity loan better?
Home equity loans can be the best choice when you need a large amount. Their interest rates are lower and the payments are smaller. But they take longer to get and often have higher upfront costs, so you probably don’t want to get one for a relatively small expense. And many experts recommend that you don’t finance short-term things (like a vacation or even a car) with long-term loans like mortgages.
So go with a home equity loan or HELOC when you need a lot of money and need a low rate and payment.
How do personal loans work?
A personal loan gets rid of a lot of financing costs and complexity because it is not secured by real estate. You apply based on your credit, income and the length of your loan term. The lender can approve and fund your loan in just days (or even hours).
There is nothing to record in local property records, and the lender cannot repossess any of your property if you fail to repay the loan. Upfront costs are generally low.
A personal loan is typically a fixed-rate debt for a given period. You get the money up front and pay it back over time. Borrow $50,000 at 10% over 15 years and the monthly cost for principal and interest is $537.
When is a personal loan better?
Personal loans can be the better choice if you don’t need a large amount, and you don’t want to be paying it off for decades. So if you need $5,000 and want to pay it off in two years, your monthly payment is $231. While fees for a home equity loan could easily come to $500. That’s 10% of your loan amount.
Personal loans can be better if you have concerns about your ability to repay. Your lender can’t take your house if you have a personal loan. They may be your only option if you lack sufficient home equity to borrow against your home.
For details and specifics for home equity and personal loans speak with loan officers. Be sure to consider both short-term and long-term preferences.