Understanding the home buying process before you start shopping for a home can make it easier.
Considering taking out a loan to pay for home improvements? Read on to find out whether a personal loan or home equity loan is the better option for you.
Improving your home can make your house a more livable place for your family — and it can also increase your home’s value when it comes time to resell. Home improvements can also be very expensive, and many homeowners are simply unable to fund major improvements out of pocket.
Whether you’re making repairs, upgrades or add-ons, borrowing to make your home a better place is common. You need to be smart about how you borrow so you don’t end up with a costly loan that’s too hard to pay back — and so you don’t put your home at risk.
Most homeowners have two good options to consider for loans to improve their homes: a personal loan or a home equity loan. There are pros and cons to each, so you’ll need to consider a few key factors to decide which one is right for you.
Home equity loans and personal loans both allow you to borrow money you can use to improve your home, but they work very differently.
Home equity loans are secured loans. Your home acts as collateral. Personal loans are typically unsecured loans, although some may be secured by assets, such as a bank or checking account. Your home does not guarantee a personal loan and, if your loan is unsecured, the only guarantee the lender has is your word.
There are differences in the qualifying requirements for home equity loans versus personal loans, as well as the typical interest rate and tax consequences of each loan type. There are also differences in the risk you face when taking a personal loan compared with a home equity loan.
You can qualify for a home equity loan only if you have sufficient equity in your home. This means you must owe less than your home is worth in order to qualify. In most cases, home equity loan providers cap the total amount you can owe on all mortgages at around 80%-85% of the value of your home. Some lenders allow you to go up to 90% or even 95%, but this is less common. Plus, you’ll usually need very good credit, and interest rates may be higher.
This requirement that you need to have equity in your home means that not everyone can qualify for a home equity loan for home improvement. If you have a home valued at $300,000 and you already owe $285,000 on the house, it’s unlikely you’d be able to borrow much — if anything — to make improvements to your home.
When it comes to qualifying for a personal loan, equity in your home isn’t an issue. Personal loan lenders look at your total debt relative to your income, as well as your credit score in order to decide whether to let you borrow and in what amount. Even if you have no equity in your home, you may be able to get a personal loan to make improvements to the house.
Personal loans typically have higher interest rates than home equity loans. That’s because the risk is greater for an unsecured loan than for a secured loan.
The specific interest rate you’ll qualify for when you get either a personal loan or a home equity loan is going to vary depending upon your qualifications, including your credit score, as well as the lender that you choose. Whatever approach you take, you should always shop around. Even carefully comparing lenders, it is very unlikely you’d be able to get a better rate on a personal loan than you would with a home equity loan.
Interest on a personal loan is never tax deductible — but you can sometimes deduct interest on a home equity loan.
Interest on a home equity loan is deductible provided that you use the money for home improvement on a primary residence that is guaranteeing the loan. The loan must be used to buy, build, or substantially improve your home. And you’re limited to deducting mortgage interest on a combined $750,000 on all mortgage loans, including your primary mortgage as well as any home equity loans you take out.
The ability to deduct interest costs can make a home equity loan much cheaper than a personal loan, especially when combined with the fact that home equity loans usually have lower interest rates. If you pay $1,000 in interest on a home equity loan and are in the 22% tax bracket, you’d save yourself $220 thanks to the fact that interest is deductible.
Finally, there’s one last big consideration: the risks you take on when you borrow.
Because home equity loans are secured by your home, they are much riskier loans. You are literally putting your home in jeopardy when you take out a home equity loan. If something happens and you cannot pay the bills for the loan, the lender could foreclose on your house.
When you take out a personal loan, you don’t take this risk. Personal loan lenders could sue you if you don’t pay. By doing so they might be able to garnish your wages and even put a lien on your property so they get paid back when you sell your home, but they cannot typically force the sale of the home to try to get repaid when you default on your debt.
As you can see, there are lots of benefits associated with using a home equity loan for home improvement rather than a personal loan. You’ll get a lower interest rate in most cases, and your interest should be tax deductible — so your loan should be much cheaper.
There are also downsides. You may not be able to qualify for a home equity loan if you don’t have enough equity, and you also put your house at risk if you can’t make payments. You’ll have to assess whether you’re willing to take on that risk in order to get a more affordable loan.
If you’re confident you can pay back your bills and you can qualify for a home equity loan, this is usually the right choice — but only you know your financial situation, so you should weigh both options carefully when deciding which is right for you.
The Motley Fool has a disclosure policy.