HELOC vs. personal loan: Which should you choose?

Do you have upcoming expenses, home improvement projects, or financial goals that you can’t afford to pay for in cash? A home equity line of credit (HELOC) and a personal loan are both good options for financing. A HELOC may offer more borrowing power than a personal loan. Still, the latter is generally less risky and comes with predictable payments. So, how do you decide between the two?

A home equity line of credit, also known as a HELOC, is a type of second mortgage. It is a secured debt product backed by your home.

A HELOC allows you to convert a portion of your home equity, or the percentage of your home you own outright, into cash. You use it like a credit card, withdrawing funds as needed up to the limit during the draw period. If you choose to make payments during the draw period, your line of credit replenishes as you make payments toward the principal balance.

The limit you receive on the revolving line depends on your financial profile, including your creditworthiness and how much equity you’ve built up. Most lenders cap HELOCs at 85% of your home equity. It’s common for the draw period to last for 10 years and the repayment period to be 20 years.

Some HELOC lenders permit interest-only payments during the draw period, making it easier to manage financially. Once the draw period ends, withdrawals are no longer allowed, and the repayment of principal and interest begins.

Read more: What can you use a HELOC for? 7 ways homeowners use the funds.

• Borrowing power: Homeowners with a lot of home equity can potentially access large sums of cash.

• Flexibility: You choose how much to borrow and only pay interest on the funds you pull out. This is great news if you don’t end up using all of the money you were approved to borrow.

• Competitive rates: HELOCs typically offer lower interest rates compared to credit cards and other loan products.

• Tax perks: The interest paid on your HELOC could be tax-deductible if you use the funds to cover the cost of significant home improvements.

• Foreclosure risk: HELOCs use your home as collateral, so missed payments could lead to foreclosure.

• Approval process: Lenders typically request a professional appraisal during the underwriting process, resulting in a lengthy application process that can last up to six weeks.

• Reduced equity: Borrowing against your equity puts you at risk of going underwater on your mortgage if the value of your home goes down.

• Fluctuating payments: HELOCs typically have variable interest rates rather than fixed. This results in fluctuating payments, which can be more challenging to manage once the draw period ends.

A personal loan is a type of installment loan, and you’ll make fixed monthly payments, usually for one to seven years. It’s typically an unsecured debt product, which means your assets aren’t at risk even if you default on the loan agreement. However, your account can still go to a collections agency, and they could sue you or garnish your wages.

Most lenders cap the amount you can borrow at $50,000, depending on your creditworthiness. The best personal loans offer up to $100,000 for select borrowers. Lenders disburse funds in a lump sum, so you’ll pay interest on the entire amount even if you don’t use the proceeds right away.

• Fast funding: Most borrowers receive personal loan funds within a few business days, and some lenders disburse loan proceeds on the same day your application is accepted.

• Seamless application process: Lenders typically accept online applications, allowing prospective borrowers to complete the process from home.

• No collateral requirement: You don’t risk losing your assets if you fall behind on loan payments.

• Predictable payments: Personal loans have fixed interest rates, which provide predictable monthly payments over a set period.

• Steeper rates: Personal loan interest rates are often higher than HELOC rates. The best personal loan rates are generally reserved for borrowers with excellent credit.

• Lending fees: It’s not uncommon to face personal loan origination fees of 1% to 8% of your loan amount. Some may charge even more.

• Interest payments: Unlike with a HELOC, you have to pay interest on the loan amount whether you spend the money or not.

• Less borrowing power: Personal loan maximums are typically lower than home equity products.

• Spending restrictions: You can use a personal loan to pay for many things, but there are more limitations than with HELOCs. For example, you typically can’t use funds from a personal loan to cover college tuition or business expenses.

The table below highlights the key differences between these two types of financing.

Learn more: Can I use a personal loan for anything? 6 expenses that are restricted.

A HELOC could be the better choice if any or all of the following apply to you:

• You’re a homeowner with a good chunk of equity in your house.

• You need to borrow more money than a personal loan could provide.

• You’re looking for a more flexible loan option.

• You can afford to make timely payments to shield your home from foreclosure.

• You want to fund costly home improvements and take advantage of the tax deductions.

• You need access to a pool of funds (or a revolving line of credit) for ongoing projects or expenses.

• You don’t have a lot (or any) home equity.

• You prefer not to use your home as collateral to secure funding.

• You have a solid credit score, which qualifies you for competitive loan terms.

• You need to access cash sooner rather than later.

• You want a fixed monthly payment over a set term rather than the variable rates that come with HELOCs.

• You want to make a large one-off purchase in the near future.

Most lenders do not impose spending restrictions on HELOCs, allowing you to use the funds as you see fit. Personal loans are also flexible, but some come with specific-use clauses. For example, if you want to withdraw funds to pay for college tuition, you’ll need to go with a HELOC instead of a personal loan. Either way, it’s worth reading the fine print to confirm permissible uses and avoid issues with your lender later on.

It depends on the lender, your creditworthiness, and other factors. That said, HELOCs generally feature lower interest rates since they are backed by collateral. Personal loans are usually unsecured debt, so you can expect to pay a higher rate, especially if you have a subpar credit score.

Are there viable alternatives to HELOCs and personal loans?

You’re not completely out of luck if a HELOC or personal loan doesn’t quite work for you. Consider a personal line of credit or a credit card instead. A cash-out refinance or home equity loan may also work, depending on your financial situation and how you plan to use the funds. Or if you’re not in a hurry to tackle the financial goal, take time to save up the money.

Laura Grace Tarpley edited this article.