Differences Between Equity & Conventional Loans

When you initially purchase a home or other real estate, you finance it with a conventional mortgage loan unless you can pay cash. However, over time you may want to restructure that financing. You have two basic options: another conventional loan or an equity loan. You'll need to know the difference between equity and conventional loans in order to make the best choice for your individual circumstances.

Identification

A conventional loan or mortgage is used to purchase or refinance real estate. When you refinance using a conventional loan, you take out a new conventional loan and use the money to pay off the existing mortgage. If you have sufficient equity in the property, you may borrow additional money as well. With an equity loan, you must have equity in the property. An equity loan or line of credit is a second loan secured by the property. Any existing mortgage is unaffected.

Function

Nearly all conventional loans are for the purpose of purchasing real estate. When you refinance a conventional loan, you probably want to secure better terms, particularly lower interest rates. You may also refinance for an amount greater than the principal of the existing mortgage in order to convert equity into cash. An equity loan, by contrast, is a means of tapping into the equity you have so you can use the money for some purpose.

Structure

When you take out a conventional loan, you borrow a large lump sum. The loan must be repaid in monthly installments. The property you purchase or refinance with the loan is collateral and the bank, mortgage broker or credit union holds the title to the property until the principal is paid in full. Interest rates may be fixed or variable. Payments on a fixed rate loan stay the same. With variable rates, payment amounts change when interest rates change. A home equity loan is structured much the same way as a conventional loan, but not as an equity line of credit. Often called a HELOC, or home equity line of credit, this type of loan is much like a credit card. In fact, most lenders now provide a card for you to use to charge purchases to the HELOC account. You have a credit limit that is usually about 75 to 80 percent of the equity in your property. You borrow money on an ongoing basis as you need it. A HELOC has a "draw period" of several years, at the end of which the right to borrow ends. Any outstanding balance must be repaid within a specified period of time.

Features

As a general rule, a conventional loan has a lower interest rate than home equity loans. Equity lines of credit tend to have higher rates, but still significantly less than other forms of consumer credit such as credit cards. With all of these loans you must pay lender's fees and closing costs, but here conventional loans are the most costly. The repayment periods for conventional loans are longer, ranging from 10 to 30 years. You typically have 5 to 15 years to repay an equity loan, and the draw periods for lines of credit are similar in duration.

Considerations

Shopping around for the best rates and terms is always a good idea. For conventional loans, even a small difference in interest rates can mean significant savings over the term of a 30-year mortgage. In addition, you may be able to get better terms if you can qualify for a mortgage backed by the Federal Housing Authority or the Veterans Home Loan program. These options aren't available for equity loans. However, equity financing is a very competitive market and lenders frequently offer incentives. This is especially true for lines of credit. You may be able to get a low introductory rate, or the lender may waive closing costs.