Key learning points
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Personal loans and mortgage loans can be a much-needed source of financing when you need cash.
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Personal loans are less risky because they are unsecured, but they often come with higher interest rates.
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Home equity loans are more accessible to borrowers with lower credit scores, but you could lose your home if you fall behind on payments.
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You may be able to access a higher loan amount with a home equity loan because it is based on your ownership interest.
Personal loans and home loans can be used for home improvements, debt consolidation, paying medical expenses and many other purposes. However, the application process and credit guidelines vary by option.
Another major difference is that personal loans are unsecured, while mortgage loans are secured and use your home as collateral. Therefore, it can be challenging to decide which one is best for your financial situation, as they both come with significant pros and cons.
Personal loans versus home equity loans
Mortgage loans and personal loans are both term loans: you pay them back over a certain period of time with fixed monthly payments.
Personal loans are typically unsecured, so there’s less risk if you can’t repay, although default can still lead to serious consequences. Being unsecured also results in higher costs and shorter terms than most home loans.
| Personal loans | Mortgage loans | |
|---|---|---|
| Loan amounts | $500 to $100,000 | $2,000 to $1 million |
| Average rates | 12% | 9% |
| Typical terms | 1 to 7 years | 1 to 30 years |
| Secured versus unsecured | Mostly unsecured | Safely at home |
| Cost | Origination fees, late fees | Origination fees, closing costs, prepayment penalties, late fees |
How personal loans work
Personal loans are a type of credit offered by banks and credit unions, as well as online lenders. They can be used to cover almost any expense, but common uses include debt consolidation, emergency expenses, moving, major purchases and recreational vehicles such as boats.
The loan proceeds are disbursed in a lump sum and paid in equal monthly installments with interest. Most repayment terms span one to seven years, but some lenders offer shorter or longer terms.
Borrowers with good to excellent credit are more likely to be approved for a low rate, lowering the overall cost of the loan. Despite this, there are quite a few lenders who work with borrowers with bad credit.
The application process is typically online and requires basic personal and financial information. To find the best deal, you should compare multiple lenders.
Plus points
- Flexibility: There are usually minimal to no usage restrictions on personal loans.
- Fast financing times: Personal loans can be approved and funded as early as the next business day, while mortgage loans can take weeks.
- No collateral required: Most personal loans are unsecured, so you don’t risk losing your assets if you fall behind on payments.
Cons
- High interest rates: Interest rates for personal loans are typically lower than credit cards, but higher than home loans.
- Lower financing amounts: Personal loans are generally limited to $100,000.
- Shorter term lengths: The maximum repayment period for a personal loan is typically seven years, compared to a maximum of 30 years for home loans.
How mortgage loans work
Home equity loans can be larger than personal loans because they use your home’s equity — the value of your home minus what you owe — to determine how much you can borrow. Most lenders allow you to borrow up to 85 percent of your home’s combined loan-to-value ratio.
A mortgage loan has one major advantage over a personal loan: a lower interest rate. But because the loan uses your home as collateral, the lender has built-in recourse if you default on payments — specifically, it can foreclose on your home.
Unlike a personal loan, the application process for a mortgage loan is a bit more complicated. Although you can often apply online, the process usually takes several weeks as your property must be assessed. You can review the options of the lender that has your mortgage and compare other home equity loans to understand how much you can borrow and what you might pay.
Plus points
- Longer terms: Mortgage loans have terms of up to 30 years, giving you a more affordable monthly payment on larger loans.
- Larger loans: The mortgage loan amounts are linked to the equity you have in your home. Depending on your assets and finances, you may be able to borrow more than €100,000.
- Potential tax benefits: The interest paid on the loan may be tax deductible if the funds are used to make qualifying improvements or repairs to the home.
Cons
- Risk of losing your home: The lender can foreclose on your house if you are unable to pay.
- Risk of having more debts than the home is worth: If the market drops and your home loses value, you may end up owing more than what the home is worth, making it difficult to sell your home.
- Equity requirements: Most lenders require that you have at least 15 to 20 percent equity in your home to qualify for a home equity loan.
When do you choose a personal loan?
In some scenarios, a personal loan may be a better choice than a mortgage loan.
- You have a smaller expense: Although you may be able to find smaller mortgage loan amounts at local credit unions, most banks set a minimum of $10,000 or more. With personal loans, on the other hand, you can only take out €500.
- You don’t want to risk your home: Personal loans are usually unsecured, so you can’t lose your home or other property if you default.
- You don’t have much equity: If you do not have enough equity in your home, you may not qualify for a mortgage at all.
- You have excellent credit: If you have excellent credit, you qualify for the lowest rates on personal loans, some of which can hover around 7 percent.
When should you not opt for a personal loan?
It is in your best interest not to choose a personal loan if you need to borrow a significant amount that exceeds the lender’s borrowing limit. You should also avoid personal loans if you can only qualify for high interest rates that result in an unaffordable monthly payment.
When do you choose a mortgage loan?
In some cases, a mortgage loan may be the best option available.
- You have a lot of equity: If you’ve built up a significant amount of equity in your home, you may be able to borrow more than $500,000 – much more than with a personal loan.
- You don’t have the best credit score: Because a mortgage loan is a secured loan, it may be easier for people with inadequate credit to qualify – just know that you won’t receive the best interest rates.
- You are looking for low rates: The interest rate on mortgage loans is generally lower than the interest rate on personal loans, which means your monthly payment will be smaller and you will pay less for borrowing money.
- You want to renovate your home: If you use your home equity loan for renovation work, you can deduct the interest paid on your taxes.
When you should not opt for a mortgage loan
Even if you could qualify for a low interest rate on a home equity loan, you should avoid it if you have very little equity in your home. The closing costs and the amount you pay in interest can easily outweigh the benefit of taking out a mortgage loan.
Another reason to skip a mortgage loan is if money is tight and you’re living from check to check. You risk losing your home to foreclosure if you fall behind on loan payments.
Alternative borrowing options
Personal loans and home loans are not the only ways to borrow a large sum of money. If you have other financial needs in mind, try one of these alternatives.
Home Equity Line of Credit (HELOC)
A HELOC works like a credit card. You’ll get a line of credit — typically up to 85 percent of your property’s value — backed by your home, and you can use this money for almost any purpose. Lenders also look at your credit score, monthly earnings-to-income ratio, and credit history to set your HELOC limit.
Most HELOCs have variable interest rates, meaning your rate and monthly payment can fluctuate. Still, HELOCs often have lower interest rates than other types of loans.
You can borrow as much as you need, as often as you want, during the drawdown period (usually 10 years). You can also replenish your available balance by making payments during the drawing period. At the end of the draw period, the repayment period begins, which is usually 20 years.
Credit cards
Today’s best credit cards offer many benefits. Paying on time every month can improve or build your credit score, and many credit cards offer cash back rewards or frequent flyer miles that you can redeem with certain airlines. They are as useful as cash and can be used as a financial safety net for emergencies.
However, credit cards have some disadvantages. Some credit cards charge high interest rates on cash advances and balance transfers. Missed or late payments can damage your credit and there is always the chance of credit card fraud on your account. Additionally, some cards have high annual fees, from as little as $25 to more than $1,200.
it comes down to
The choice between a personal loan and a mortgage loan depends on your financial needs. Both loan types have pros and cons that you should consider before applying, but both are suitable options if you need to borrow money. Either way, take the time to compare all your loan options, interest rates, fees and repayment terms before submitting your application.
