Ask Yourself These Questions to Decide Whether to Take Out a Personal Loan or a Home Equity Loan

If you need to borrow money, there are different ways you could do it. A personal loan could be one option. If you are a homeowner, a home equity loan could be another. But there are important differences between these two borrowing methods.

How can you decide which is right for you? Just ask yourself these key questions.

What do you need the money for?

If you are borrowing to do home improvements, a home equity loan could potentially be a better option because you may be eligible to deduct the interest on your taxes if you itemize. This is typically allowed if you use the proceeds from the home equity loan to buy, build, or substantially improve the home that is guaranteeing the loan.

If you're borrowing for some other reason, you can typically still use a home equity loan. You can use the proceeds for just about anything when you tap into your home's equity. But the interest will not be tax deductible.

How much do you need to borrow?

When you take out a home equity loan, you can only borrow a set amount based on the equity you have in your home.

Most home equity loan lenders cap the total amount of your mortgage and home equity loan at somewhere between 80% and 90% of your home's value. So if you have a $250,000 house and already have a $200,000 mortgage, you'd only be allowed to borrow between $0 (if lenders capped total loans at 80% of value) and $25,000 (with a 90% cap). If you needed to borrow more than that, you'd be out of luck.

With a personal loan, there are lenders that allow you to borrow up to $100,000. However, the specific amount you can borrow is based on factors like your credit score and income. If you have solid financial credentials, you may be able to borrow more with a personal loan if you don't have much equity in your house.

How much risk are you willing to take on?

A personal loan isn't secured by your house. A home equity loan is. If you take a home equity loan, you risk losing your house to foreclosure if you default (stop making payments). You may not want to take that chance.

With a personal loan, you're still expected to pay as promised and could face collections activity if you don't. But that's not likely to lead to foreclosure, so you're taking much less of a risk of devastating financial loss if something goes wrong.

Is a low interest rate or low upfront costs more important?

When you take out a home equity loan, you have to pay closing costs just like you do when you get a first mortgage loan. This can include expenses like an appraisal fee and an origination fee. The fee could add up to around 2% to 6% of the amount you're borrowing. So if you got a $50,000 loan, you could owe as much as $3,000.

By contrast, many personal loan lenders allow you to borrow with no upfront origination fees. Home equity loans do often come at lower interest rates than personal loans, though, since they are secured loans. You'll have to ask yourself if you'd rather pay higher fees upfront for a home equity loan at a lower rate or get a personal loan with lower fees and a higher rate.

Both a personal loan lender and home equity loan lender should disclose borrowing costs, including upfront fees and total interest over time, so you can compare these costs to decide what makes sense.

By asking yourself these questions, you can make an informed choice about the best borrowing method for your particular situation.