Home Loan vs Personal Loan
Which, in your opinion, is the better option? I am about to get a home improvement loan for $18,000. One option is to get a second mortgage loan @ 3.73% APR. With this loan, I’d have to pay $800.00 in closing costs plus $15 per month in PMI. Or I can get a personal @ 6.60% APR for 60 months. Both have no prepayment penalties.
Thank you for your question. To help you find the best answer, it will be necessary for me to make some assumptions. First, I assume that the “home improvement” loan will be a second/subordinate mortgage on your home. As such, I will use a 15-year term as the basis for determining your monthly payments and the loan’s amortization. For the personal loan, I will assume a straight 5-year/60-month term with equal installment payments.
Totaling up costs on the home improvement loan
For the home improvement loan, with a 15-year term and a 3.73% rate, you would have a monthly P&I (principal & interest) payment of $130.72, plus $15 for the PMI, thus totaling a monthly payment of $145.72. If seek to pay off the loan balance at the end of 60 months, it would require a balloon payment of $12,896; that’s the remaining principal balance at the 60-month mark.
In total, you would pay about $2,960 in interest over 5 years, plus $900 in PMI and $800 closing costs. Your total cost of the home loan would thus total about $4,660 at the end of the 5 years. Should you choose to maintain the loan for the full 15-year term, your total interest cost would be about $5,530; when you add in the $800 closing costs and $2,700 in PMI costs, the total cost would be roughly $9,030.
Comparing costs on the personal loan
By comparison, a 5-year/60-month (installment) loan with a rate of 6.6% APR would result in a monthly payment of about $353. Total interest cost for the loan over the course of the 5-year payoff would be $3,182.
So clearly, the 5-year installment loan would have lower total cost after payoff in 5 years, when compared to the 15-year loan. With a balloon payment at the end of 5 years and total interest, PMI and closing costs of about $4,660 at that 5-year mark, that’s still higher than the $3,182 on the personal loan. That means strictly from a cost perspective, the personal loan would generally be the better option.
Better isn’t always right, depending on your situation
Although the personal loan has lower costs, that doesn’t make it the right choice regardless of your situation. As to which loan is the “better option”, the answer is that it depends.
Besides total cost, monthly cost is another key factor when you consider new financing. Will the $353 monthly payment of the personal loan fit your budget? Or, do you need a lower payment, like $131 on the home improvement loan?
Similarly, consider the likelihood of you coming up with the balloon payment at the end of 5 years. You will need nearly $13,000 should you choose to extinguish the home improvement loan at the end of 5 years. The advantage of the home improvement loan is that it grants you more flexibility with respect to your cash flow; you can also choose to make additional payments as your finances allow. This would mean that any early extinguishment of the loan would require a smaller balloon payment at that 5-year mark. As such, you should consider the advantages of leverage offered by the longer-term home improvement loan.
Additionally, with lower payments, you may choose to invest some of your available cash flow. If the return on that capital is greater than the cost of borrowing, then you achieve positive leverage and effectively lower the total cost of borrowing that money.
Yes, there is much to consider. Which direction you choose is actually tied more to your needs and resources, rather than simply interest and borrowing costs.
I hope this information helps you to make a more informed decision!
Jeffrey Schwartz is the Executive Director of Consolidated Credit Counseling Services of Canada and President of the Credit Association of Greater Toronto (CAGT).