Personal loans can provide quick and relatively painless financing for small home improvement projects when a home equity line isn't practical or even available.
You're a newish homeowner, and you need money. Maybe a pipe burst in your bathroom, and it's going to cost a few thousand to fix, and you can't just do without a shower for a year while you squirrel away the money to get it working again. Or maybe you'd like to get rid of the ratty futon that's followed you from dorm room to apartment to starter house.
In an ideal world, you'd have savings or an emergency fund big enough to cover these expenses, but this isn't an ideal world. Yes, you could charge the cost of your new couch to a credit card, but you'll pay a ridiculous APR and risk falling into a cycle of making a minimum payments while your balance goes nowhere. And if you need to make repairs or renovations, you might find your contractor is old school and cash-only.
You have a couple of options (aside from receiving a wad of dirty bills on a darkened street corner from a beefy guy named Chad):
- A home equity loan
- A personal loan
Both offer a fixed interest rate, a fixed term, and a fixed monthly payment. Each has their advantages, but personal loans have become a popular option for people who need to borrow a significant - but not huge - sum of money quickly.
Personal loans vs home equity loans
Personal loans can be acquired more quickly than home equity loans
A home equity loan (or a home equity line of credit, which is slightly different) draws upon the equity (hence the name) you've accrued in your home (typically some percentage of the value of your home minus the amount still due on your mortgage).
So, if your home is worth $200,000 and you still owe $150,000, then you've got $50,000 worth of equity. In some cases, you might be able to get a home equity loan for that full $50,000 at higher-than-average interest rates.
To get the most competitive interest rates, however, banks will cap the total amount you can borrow worth of equity. In some cases, you might be able to get a home equity loan for that full $50,000 at higher-than-average interest rates.
To get the most competitive interest rates, however, banks will cap the total amount you can borrow (your outstanding mortgage principal plus your home equity loan) at 80 percent of your home's appraised value. (This is called a combined loan-to-value ration.)
In the above example, you could only borrow up to $10,000 (80% of $200,000 = $160,000).
Assuming you have the equity to apply for a home equity loan or line of credit, the bank will need to appraise your home. An appraisal take time and costs around $500.
There's no such process for a personal loan. Borrowers can be approved within hours (according to Wells Fargo, in as little as 15 minutes) and receive their money within a few days. That's important when you need to make a purchase or pay for a repair now, instead of in a few weeks or months.
Personal loans can be for small amounts
Banks don't really want to bother with the home equity process for small loans. Bank of American requires a minimum of $25,000 for a home equity loan, while Wells Fargo will go no lower than $20,000. That's probably a lot more than you need for a new couch or bathroom repair.
And if you're thinking you can just take the big check, and then immediately pay back what you didn't use, think again: banks often have a prepayment penalty that applies if you pay your home equity loan back before the term is up. The prepayment penalty can be steep - even up to 10 percent of the original loan amount.
Personal loans, on the other hand, are available in much smaller amounts. At Wells Fargo, you can take out as little as $3,000; at TD Bank, as little as $2,000; and at LendingTree, as little as $1,000. Most don't have prepayment penalties.
Personal loans don't put your house at risk
Home equity loans come with low interest rates (often about 5 percent, regardless of the borrower's credit history) because the house acts as collateral. If the borrower can't keep up with payments, then the bank can foreclose on the house to recoup their money.
It's really important to be sure you can keep up with the payments before taking out a loan against the value of your house. You're basically taking out all the money you've spent years putting into it, and you shouldn't do that without a really good reason. In addition, if the value of your house takes a hit (which, as we say in 2008, can definitely happen) then you can end up owing more on your house than the house is worth.
Personal loans, on the other hand, are unsecured, which means they have no collateral, so you're only risking your own credit score a lot of headaches if you can't pay back your loan. The bank can't come for your house.
Because personal loans are unsecured, you'll need decent credit to get a good rate
Because there's no collateral on a personal loan, banks look more closely at a potential borrower's credit to determine if they're a good risk. (It's possible to get a secured personal loan at some banks -- like TD Bank -- where the collateral is a money market account or savings account, but that probably only makes sense in a world where the interest earned on those kinds of accounts exceeds that of the interest you'd pay on your personal loan, and we do not live anywhere near that world.)
If you've got an excellent credit score -- that means at least five years of credit history with no late payments -- you may qualify for an APR of 8 percent or less. With a shorter credit history, rates may still be better than credit cards -- between 10 and 15 percent. If you've got a spotty financial record, you might get approved for a rate that's much higher (at a peer-to-peer lending service like Lending Club, rates can go up as high as 32.9999 percent!) We can't think of a situation in which we would recommend a loan at that rate to anyone.
Remember
Personal loans are great if...
- You need a small amount of money relative to home equity loans (between $2,000 and $20,000)
- You've got a good credit score (650 or above)
- You feel uncomfortable putting your house at risk, or are worried about shifts in the market
Home equity loans might make more sense if...
- You need a larger loan (more than $25,000)
- You've got a spotty credit history, but are on solid financial ground now
- You've built up a significant amount of equity in your house, and feel secure about your ability to pay your loan back
Things you should keep in mind for both home equity and personal loans
- Read the fine print to be aware of any and all fees (origination, prepayment, etc.)
- Be sure it's money that you actually need, not just money that you want
- Have a plan to pay back the loan before you apply
Comments
Post a Comment