Should you take out a personal loan or a home equity loan? After all, they can both be used for similar purposes.
We discuss these two types of loans here and help you make the best decision for you. Seek personalised money advice from a debt charity for further support and clarification.
How do home equity loans work?
A home equity loan is a type of loan used by homeowners to access a lump sum from the equity they have in their home. This money can then be used for many purposes, such as debt consolidation, home renovations, education or to help family members out financially. To understand how a home equity loan works, you need to know what home equity is.
Home equity is the difference between how much you have left to pay on your current mortgage (if you have one!) and the current value of the property. It’s crucial that this calculation takes into account current market value and not what the property was worth when the mortgage was taken out. The value may have decreased or increased since then for various reasons.
For example, if you bought a property for £250,000 using a £50,000 deposit and a £200,000 mortgage, you will instantly have £50,000 equity in the property. If you pay off a further £50,000 of the mortgage your equity rises to £100,000. And if the home were to increase in value by £25,000 to £275,000, your equity increases to £125,000. As you can see lots of factors can affect how much equity you have in your home.
A home equity loan allows homeowners to borrow up to the maximum amount of equity they have in their home, although most lenders will only allow up to 85%. For example, if you had £100,000 of equity you may only be allowed a home equity loan up to £85,000. The loan is secured against the equity in your home as collateral, and the lender might force you to sell the property if you fail to repay.
Home equity loan vs HELOC
Home equity loans allow the homeowner to access a lump sum instantly, but an alternative is a home equity line of credit, which functions somewhat similar to a credit card. It enables the homeowner to access credit in stages as they wish. Home equity loans usually have a fixed interest rate and HELOCs have a variable rate.
How do personal loans work?
Personal loans are loans from banks, building societies and online lenders. You will take out a set amount of money, usually between £500 and £25,000 to be repaid over a set period with a fixed interest rate. Once all repayments have been made the loan is finalised.
Personal loans are usually unsecured, meaning no assets or collateral is listed within the agreement. If you fail to make repayments in full and on time, the lender does not have automatic access to your home or any other assets, such as a car.
However, if you do not repay your personal loan then the lender can leave defaults on your credit file, which makes it more difficult to take out further credit. They can also take you to court and a judge could give the lender the right to chase you using bailiffs or other enforcement means. A bailiff may then be able to repossess your assets to an equal value of the debt owed.
One of the alternative methods of debt enforcement is a charging order, which could make you sell your home to repay the loan, although this is unlikely for smaller amounts.
Is it better to get a home equity loan or a personal loan?
There is no fixed answer to this question. The best option will depend on your personal circumstances, credit score, available loan options and reasons for needing the credit. However, there are some standard examples of when it may be better to choose one over the other.
Consider the points below before deciding on either, and seek free advice from a charity, especially if you require credit for debt consolidation purposes.
When to choose a personal loan
- If you only need a small amount of credit you will probably be better off with a personal loan. Most home equity loan providers have a minimum amount of around £10,000 or more.
- If you do not want to risk your home then you should consider an unsecured personal loan.
- If you are early in your mortgage with little equity then it may not be wise or advantageous to use a home equity loan over a personal loan.
- If you have an excellent credit score then you’ll be able to access an unsecured personal loan with a low-interest rate, and you may even be able to compete with the lower interest rates within the best home equity loans.
When to choose a home equity loan
- You need to borrow a significant amount for a big purchase or home renovation and you have paid off most or all of your mortgage. You may be able to access significantly more credit through a home equity loan than you ever could with the biggest unsecured personal loans.
- A home equity loan could provide you with a better deal if you have an average or poor credit score. Due to these loans being secured against your home’s equity, they are still accessible and provide better rates than you can find elsewhere with a poor credit history.
- On average, home equity loans tend to have lower interest rates than unsecured personal loans. This is also because they are secured against the property equity and offers reduced lending less risk to creditors.
How much is the closing cost on a home equity loan?
When you have a home equity loan there is a fee to close the loan, known as the closing cost. This cost is normally somewhere between 2-5% of the total loan balance, meaning it can be expensive if you access a significant amount for equity. You should keep this in mind when deciding between a personal loan or a home equity loan.