When you’re making significant improvements or repairs to your home, the costs can add up quickly, especially when you hire a contractor to do the work. Sometimes the total price can reach tens of thousands of dollars, and most of us don’t have that kind of money lying around.
Luckily, there are several ways homeowners can finance large home improvement projects. Two of the most popular financing options are personal loans and home equity loans.
Let’s determine which option is best for your home improvement, addition, or repair project.
What are home improvements?
Home improvements are changes made to a residential property to enhance it in some way. Types of improvements can include repairs to a condominium, renovations to a house, remodeling a manufactured home, building new structures, landscaping, or similar work.
For example, you might have a plumbing or electrical issue that needs repair, want to replace the cabinetry and colors in your kitchen, change the layout of your main bathroom, or add a detached garage to your home.
You can categorize home improvements as almost anything you can imagine doing to a home you own and the property it sits on.
What is a personal loan?
A personal loan is an installment loan that allows you to borrow money from a bank, credit union, or online lender and repay it over several months or years.
It is typically unsecured, meaning you don’t have to put up collateral, such as your car or house, to borrow the money. Instead, lenders put more emphasis on your credit score, debt-to-income (DTI) ratio, and income to determine how much you can borrow. These details will also influence the interest rate and what origination fee, if any, to charge.
Personal loans have a set monthly payment and a term length that typically ranges from 1 to 7 years. Their interest rates are generally fixed and won’t change over the life of the loan. You can use a personal loan for almost any purpose, including home improvements, and receive funding within a few days.
What is a home equity loan?
A home equity loan (HEL), also known as a HELOAN, is similar to a personal loan, except you use a portion of the equity in your home or other property you own as collateral to borrow the money.
Even though you are using your home’s equity as collateral, the consumer requirements can be similar to those for a personal loan. But lenders can offer lower rates and higher borrowing limits.
Like personal loans, home equity loans generally have fixed interest rates and monthly payments, but standard repayment terms range from 5 to 30 years. Home equity loan interest rates are usually lower than personal loan rates, especially for borrowers with lower credit scores.
In most cases, borrowers can use the funds for a significant home improvement project, major repairs, or any other purpose they desire, but getting approved and funded can take weeks.
Quick comparison: Personal loan vs. home equity loan
| Loan type | APR | Term length | Amount | Funding |
|---|---|---|---|---|
| Personal loan | Low–high | 1–7 years | $1K–$50K | 1–7 days |
| Home equity loan | Low | 5–30 years | $10K–$500K | 2–8 weeks |
Which one should you choose?
There are several factors to consider when assessing whether a personal loan or a home equity loan is better for your home improvement projects:
- Project cost: Which option meets your funding needs?
- Urgency: How quickly do you need the cash and project completed?
- Home equity: Is there enough equity in the property to get a home equity loan in the amount you seek?
- Long-term plans: Do you plan to stay in the property for a while, or are you planning to sell soon?
- Monthly payment: How much money do you want left over after you pay your bills each month?
- Creditworthiness: Which choice is cheapest for you?
- Overall cost: How important is the total cost of borrowing money?
- Flexibility: Do you prefer lower payments with the option to pay off the loan early, regardless of costs?
- Property usage: Is this your permanent residence, a rental property, or other real estate?
- Security: Are you willing to surrender the property if you can no longer make the loan payments?
- Taxes: Will you be itemizing your deductions or taking the standard deduction at tax time each year?
When a personal loan is better for home improvements
A personal loan is often better than a home equity loan for minor home renovations, remodels, updates, and emergencies. The quick approval process and low upfront fees make them ideal for homeowners who need cash quickly.
They are also attainable for homeowners with little home equity since there is no home equity requirement for a personal loan. Someone who recently bought their home won’t have much, if any, equity to use as collateral for a home equity loan.
If you can afford the monthly payments, a personal loan can also be better because it will force you to pay off the debt faster than a home equity loan, and it doesn’t put your home at risk if you are unable to pay in the future.
When a home equity loan is better for home improvements
A home equity loan is best suited for large home improvement projects, home additions, and major repairs. Borrowers need to have a decent amount of equity in their property, usually from living in it for several years or from making a large down payment when it was purchased.
Home equity loans can be ideal if you are not in a hurry and plan on owning the property for many years to come. They are also best if you prefer a lower monthly payment with the ability to pay off the loan sooner, rather than being forced to make large monthly payments.
A home equity loan can also be better if you itemize your tax deductions because you may be able write off the loan interest, which could add up over the life of the loan.
Other considerations (fees)
In addition to the annual percentage rate (APR), there are other fees to consider when deciding between a home equity loan and a personal loan.
The fees I’m most concerned about are the ones charged to originate and pay off the loan, such as closing costs, origination fees, and prepayment penalties. Your APR should reflect the cost of most upfront fees, but not prepayment penalties and other related payoff costs.
Home equity loans can have a variety of closing costs, including origination and other fees, and may require you to obtain homeowners’ insurance if you don’t already have it. Some fees and their amount will depend on your credit score, while others will be the same regardless of your credit. However, they may vary depending on the city, county, or state where the property resides.
For example, last year I was billed for a reconveyance fee for closing my home equity line of credit, which I had for about 9 years. I wasn’t using it and didn’t want to keep paying the $50 annual fee to keep it open. However, I had to pay an additional $303.50 to have the lender release the lien in the county where the home is located.
The lender also puts a lien on your property for a home equity loan.
Personal loans, on the other hand, typically only charge an origination fee. The amount charged often depends heavily on your financial situation and credit score. The origination fee may go by other names, such as an administration fee or another name representing the cost to originate the loan.
It is less common to have prepayment penalties on a personal loan, and you don’t have to worry about removing property liens.
It can be tricky when comparing the costs between the two, because if you obtain a home equity loan with a low APR and repayment period of 30 years, then decide to pay it off early, the upfront fees could end up costing you more than it would have with a higher APR and shorter-term personal loan.
How to get a personal loan
Many local banks and credit unions provide personal loans, but you can also find and compare them through online marketplaces like APR finder.
Several online lending platforms allow you to see if you qualify for a personal loan without affecting your consumer credit score. They do this by running a soft credit check rather than making a hard inquiry.
When presented with an offer you like, accept it, then proceed with the application by filling out any remaining forms and submitting documents to verify your identity, income, and debts.
Once you submit the formal application, most lenders will thoroughly check your credit report by doing a hard pull, which could slightly impact your credit score.
A personal loan can be obtained in person or online, oftentimes with instant approval and funds disbursed in as little as one business day. However, it usually takes a couple of days for the funds to reach your bank account.
Qualification requirements for a personal loan
You can qualify for a personal loan with a credit score as low as 580, but we have found that a score of 640 or higher significantly improves your chances of approval. For the best rates and competitive offers, aim for 720 or above.
You will also typically need a debt-to-income ratio of 50% or less, and no recent bankruptcies or delinquent accounts. However, many lenders will suggest a DTI below 43%.
Individuals with poor credit may be able to obtain a small personal loan on their own, or they can use a co-borrower or co-signer to secure a loan with some companies.
The qualification requirements for a personal loan can vary by lender, loan amount, and state.
How to get a home equity loan
You can apply for a home equity loan with most banks, credit unions, mortgage brokers, and independent mortgage companies, in-person or online.
If you have your financial documents in order, you can complete the application quickly. However, the approval and funding process typically takes 2–8 weeks as the lender needs time to review your personal information and evaluate the property.
Qualification requirements for a home equity loan
To qualify for a home equity loan, you will typically need a credit score of at least 620, with 660 or higher recommended. Then, you may find a lender that allows a debt-to-income ratio up to 50%, but a DTI of 42% or lower is often preferred.
Similarly, someone with solid income and excellent credit may be able to find a home equity loan for up to 100% of a property’s combined loan-to-value (CLTV), but most home equity loans are for less. Usually 80–90% CLTV.
Here’s an example: If you have a primary mortgage loan of $400,000 and the property is worth $600,000, your loan-to-value (LTV) is 67%. If the lender offers home equity loans with a CLTV of up to 80%, you could take out a $78,000 home equity loan (13% LTV). Assuming you have no other mortgages on the property.
Combined loan-to-value = total secured loan balances / appraised value. In our example, a $400,000 primary mortgage plus a $78,000 home equity loan, divided by the appraised value of $600,000, equals 80%.
Home equity loans are not as accessible to people with poor credit scores, but you can also use a co-borrower or co-signer to secure the loan.
Alternative borrowing options
There are many benefits to homeownership. One of them is the ability to borrow money using methods not available to renters. Oftentimes, they’re cheaper, too. When comparing personal loans and home equity loans for home improvement projects, you should also check out these borrowing options.
- Home equity line of credit (HELOC): A hybrid between a credit card and a home equity loan that allows you to use your home as collateral to obtain better interest rates. The annual percentage rate on a HELOC is typically lower than that of personal loans, but they’re commonly variable, and you will likely face more upfront fees.
- Cash-out refinance loan: Allows you to refinance your home for more than you currently owe and take cash out to use for home improvement projects. A cash-out refi will give you the lowest APR, but it could increase the current rate you are paying on the entire loan, costing you significantly more in the long run. It will also include typical mortgage closing costs, as it replaces your original loan.
- Home equity agreement (HEA): Best for people with bad credit who need cash for a significant home improvement project. Technically, an HEA isn’t a loan. It’s a contract between you and an investor company. You sell an ownership stake in the future value of your property in exchange for cash. The time it takes to receive money from a home equity agreement is similar to that for home equity lending options.
- Credit card: A convenient way to get cash fast. You can charge the items you need to your card, or withdraw some money using balance transfer checks or a cash advance. The borrowing cost with a credit card is typically the highest, unless you take advantage of an intro APR promotion and pay it off within a short period. You will generally need very good to excellent credit for large credit lines and top intro offers.
- Personal line of credit (PLOC): PLOCs are unsecured revolving lines of credit with smaller borrowing caps that don’t require you to use your home as collateral. They can be hard to find, and eligibility requirements are strict. Most have variable interest rates that can cause a fluctuating monthly payment, even when you withdraw the money as a lump sum. They’re hybrids of credit cards and home equity lines of credit.
- Buy now, pay later (BNPL): Provides a unique way to borrow money for small home improvement projects, repaid over several weeks or months. Interest rates are similar to personal loans, but you may be able to find interest-free offers through major retailers at checkout, in-store, and online. BNPL is a convenient option for single purchases, but it can be challenging to manage when using it for multiple purchases.
Final thoughts on personal loans versus home equity loans for home improvement
If you need quick access to cash with predictable monthly payments, a personal loan could be a great fit. If you need a higher dollar amount or a lower monthly payment, a home equity loan may be better, especially if you plan to own the property for a long time.
No matter which financing option you choose for your next home improvement project, you must manage your debt wisely. Both personal loans and home equity loans make that easier with fixed monthly payments and interest rates.