While personal loans and mortgages are both lending products, they tend to serve very different purposes. Whether you are considering buying a home or looking to take out a loan using the home you already own, having a proper grasp of what financial products are available to you and for what purposes is necessary for thorough financial knowledge.
Firstly, we will break down the differences in how a personal loan and mortgage function and in what circumstances should you obtain one over the other. A home equity loan is a lending product somewhere in between the standard mortgage loan and personal loan. Home equity loans can be an excellent way for homeowners to borrow money at an affordable interest rate.
The Differences Between a Personal Loan and Mortgage
Even though personal loans and mortgage loans offer financing for large purchases, they have several critical differences in what they are used for and how they function on the whole.
Mortgage
A mortgage loan is a type of secured personal loan used specifically to purchase a home or a piece of land on which you plan to build a house. About 42% of households in America have a mortage.1 The money granted in a mortgage is secured through the home equity value of the home you are purchasing. The unique nature of mortgage loans allows borrowers a large amount of money to purchase their home with low-interest rates and repayment terms of up to 30 years.
Personal Loan
Personal loans can be far more versatile than mortgage home loans, as you can use a personal loan for any number of things. Personal loans can be used for home improvement projects, debt consolidation, or car repairs. Unlike mortgage loans, most personal loans are unsecured. According to the credit bureau, TransUnion, there were about 22.4 million Americans who had an unsecured personal loan as of the beginning of 2023.2 An unsecured loan doesn’t use any kind of equity as collateral which means that they usually have higher interest rates. However, borrowers with excellent credit can usually obtain a reasonable interest rate. Terms for personal loans generally range between one and seven years. Lenders also usually just require a few personal loan documents, including:
- Proof of ID
- Proof of income or IBV
- Proof of residency
- Bank account information (sometimes)
Though personal loans and mortgages are not interchangeable, it is still essential to understand how both of them work so that you can be prepared when you need one or both in the future.
How Personal Loans Work
You can find personal loans offered by online lenders, banks, and credit unions. The variety of personal loans is immense. You can obtain a large personal loan for consolidating debt or costly home repairs. But you can also find personal loans that offer a small loan amount for funding to make it to your next paycheck. There are personal loans with an excellent, low-interest rate for people with good credit scores and personal loan options of poor credit installment loans with higher interest rates.
Personal loans are likely one of the most versatile financial products to exist. Personal loan rates and the loan amount will change depending on the borrower’s credit score and the purpose of the loan. All personal loan lenders have different requirements to qualify, so it’s a good idea to look into multiple lenders to see which one best meets your needs.
How Mortgages Work
You will likely find a mortgage lender at a financial institution like a bank or credit union. Your mortgage will be secured with the value of the house or land you are purchasing. A substantial down payment is usually necessary, and you will be required to purchase mortgage insurance.
While there are personal loans for people with bad credit, being approved for a mortgage typically requires a decent credit score. Borrowers with good credit or excellent credit will be able to access even better interest rates on their mortgage. For this reason, many people wait to build their credit history before purchasing a home so they can get a low-interest rate with more affordable monthly mortgage payments.
Loan repayment terms on a mortgage can last between eight and 30 years which is why the lenders require the security offered in a down payment, a good credit score, mortgage insurance, and a solid debt-to-income ratio.
What About Home Equity Loans?
Where you start to find some middle ground between a mortgage and a personal loan is with a home equity loan. Often referred to as a second mortgage, a home equity loan is a way for homeowners to use the equity built up in their home from the monthly payments they’ve made on their mortgage to take out loans.
Home equity loans are similar to personal loans in that they can be used for various purposes. The terms for a home equity loan will last between five and 15 years, with many lenders willing to let you borrow up to 85% of your combined loan-to-value ratio.
You can get lower interest rates on home equity loans as they are secured through the equity you’ve been building in your property. Your home is used as collateral for these loans, which makes it vital that you make your loan payments on time each month.
Home Equity Loan vs. Personal Loan
If you are a homeowner, you might be unsure whether you should rely on a home equity loan or a standard personal loan to obtain some needed funding. The answer is not as simple as a yes or no. Which lending product is best for you depends on your current situation, your credit history, and how much money you need.
A home equity loan could be the right direction to go if you have a substantial amount of equity built up in your house and you need a more considerable loan amount. If you go with a home equity loan, you can access an extended repayment period with lower monthly payments. A personal loan will likely have higher interest rates unless you have excellent credit, so a home equity loan might give you more affordable rates if you don’t have optimal credit.
Conversely, it may be wiser to use a personal loan if you don’t need a large amount of funding. It’s possible to find personal loans in smaller amounts, whereas home equity loans usually have minimum requirements. If your credit report is in good shape, you could access a reasonable interest rate on a personal loan without needing to secure the loan with your home as collateral.
Affording Your Monthly Payments
One feature that all these loan types have in common is the existence of fixed monthly payments. Whether you’ve taken out a personal loan, a mortgage, or a home equity loan, your loan agreement will stipulate that you make on-time payments.
Consistently making late payments or missing payments altogether on any of these loan options will have detrimental consequences on your credit scores. In addition to harming your credit score, defaulting on your mortgage or your home equity loan could put your house at risk of foreclosure.
Tips For Budgeting for Your Monthly Payment
If you are struggling to afford your payments on your personal loan or mortgage with your monthly income, we can recommend a few tips for budgeting your loan repayment so you can protect your credit score and place of residence. Creating a budget for your household that includes your loan payments will help you stay on top of paying off your debt while keeping the rest of your finances on track.
Cut Down On Expenses
If you struggle to fit your personal loan payment into your monthly expenses, see what you can cut down on. There might be unnecessary spending you can erase from your budget, even temporarily, to make room for your loan payments. Canceling some streaming services or subscriptions could add another $100 or $200 to your cash flow.
We encourage you to sit down and analyze your cash flow with your bank account statements. You might be surprised how much money you spend on things that could be considered wants rather than needs.
A superb outline to follow if you aren’t sure how to divide up your income is the 50/30/20 budget. Allocate 50% of your budget for needs, 30% for wants, and 20% on debts and savings. Looking at your bank statements could highlight that you are spending 40% of your paycheck on wants, and that’s why you can’t afford your monthly payments. Simply reallocate 10% of that to your debts.
Get an Emergency Fund
You might ask how saving money helps to budget for debt payments? Well, every single time an unexpected or emergency expense comes up, and you don’t have an emergency fund to cover it, you are forced to use your monthly cash flow. Using your monthly budget to pay for all those surprise expenses leaves less money to take care of the normal necessary costs like loan payments.
Having a $1,000 emergency fund will make sure that the entirety of your paycheck can be used for your monthly budget. Using the money you had designated for your mortgage payment to make emergency repairs to your car so you can get to and from work is a recipe for disaster and default.
Increase Your Income
An inability to afford your loan payments is a sure sign of a high debt-to-income ratio. Not having enough cash flow can make it challenging to budget for important expenses like debt. It might be a good time to ask your boss for that raise you’ve been working towards. Or you could take on a side hustle or ask your employer about working overtime so you can earn a bit more money on the weekends.
Getting a second job doesn’t need to be a long-term solution. Increasing your income temporarily could help you get back on track or hold you off until you find a higher-paying job. It’s essential to be open to exploring your options so you can find something that works for you.
Talk to Your Lender
Communicating directly with your lender is crucial when you are struggling to afford your monthly payments. Most lenders would prefer to work directly with you to figure out a solution to make your payments more affordable over you defaulting on your loan. Being transparent and communicative with them will prove that you are committed to repaying your loan despite less than ideal circumstances.
You never know what options are available until you ask. Frequently, lenders are prepared for eventualities just like this. Deferment or new terms might be possible if you explain the situation to your lender and tell them exactly how much you can afford to pay each month.
CreditNinja’s Thoughts on Personal Loans and Mortgages
CreditNinja knows one of the best things you can do for your financial health is to properly research and educate yourself on the products you are considering. The one sure way to harm your chances of being successful in a financial venture is to not understand what you are getting yourself into. CreditNinja always encourages consumers to read the reviews on multiple lenders before you apply for any type of loan.
Research background information and licensing on online lenders to be sure they can be trusted. Know beforehand how each decision you are considering might impact your credit score. Being proactive in knowledge-seeking will empower you to make decisions that lead you to a future free of financial stressors.
Ready to learn more about bad credit loans, mortgages, and more? Head over to the CreditNinja blog dojo for hundreds of resources like articles, debt calculators, and other tools to help you make the most of your finances!
References:
1. Average American Debt | Ramsey Solutions
2. Credit Card and Unsecured Personal Loan Balances Remain at or Near-Record Levels as Consumers Navigate Challenging Economic Climate | TransUnion
3. Loan vs Mortgage – Difference and Comparison | Difference
4. Can You Use a Personal Loan for a Home Down Payment? | ValuePenguin
