When it comes to taking out a loan against the equity in your home, there are at least two options: the reverse mortgage and the home equity loan. Both options allow you to tap into the equity of your home, but they have their differences, and it’s important to understand each.
A reverse mortgage is a home loan that will allow a homeowner as young as 55 years old to access the equity in their home without having to make monthly payments (some reverse mortgages require the borrower to be at least 62 years old, read below for more details). The reverse mortgage is repaid when the home is sold, the borrower moves out or passes away.
On the other hand, a home equity loan, also known as a second mortgage, has no age limit but requires the borrower to make monthly payments. The borrower of the home equity loan typically repays it over a period of 5–30 years.
To help you build more wealth from your home equity, today we will look at reverse mortgage vs. home equity loan: which is the better option? It depends on your circumstances. Here we take an in-depth look at reverse mortgages vs home equity loans, plus their advantages and drawbacks to.
How reverse mortgages and home equity loans work
Reverse mortgages and home equity allow to tap into the equity in your home to get extra cash. But how do they differ? First, let’s discuss how each works.
How does a reverse mortgage work?
For one, a reverse mortgage is a home loan specifically designed for seniors who are 55 years of age or older. It allows homeowners to access a portion of their home equity and use it as retirement income.
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It’s important to note that the homeowner is expected to adhere to loan conditions set out, which include keeping the home in good condition, paying property taxes, mortgage insurance, and homeowners insurance. In addition, you need to continue occupying the home as your primary residence.
A reverse mortgage loan is the opposite of a regular / normal mortgage. If you have an existing mortgage, the lender will pay it off and lend you the balance of your equity. You will receive the money in one of the following ways:
- Lump-sum payment: You get the entire loan amount all at once at a fixed interest rate.
- Tenure: The lender will send you fixed monthly installments as long as you live in the home.
- Term: For a set period, you will receive equal monthly payments.
- Line of credit: Under this arrangement, you turn your equity into money you can use for projects. You pay interest and fees on what you have borrow.
- Modified tenure: A modified tenure encompasses both lines of credit and fixed monthly payment.
- Modified term: A modified term allows you to receive fixed payments plus a line of credit for a certain period.
The money you receive to fund your retirement will accrue interest, increasing your debt. This is in return for the equity in your home. As the lender gives you money, your equity decreases.
Three common types of reverse mortgages
Reverse mortgages are either single-purpose reverse mortgages, home equity conversion mortgages (HECM), or proprietary reverse mortgages. Here is a brief overview of how each works.
Single purpose driven mortgages
You can get single-purpose mortgages from state, local, and non-profit agencies for use in a specific way. As the name suggests, the money you get can only be used for one lender-approved purpose.
Because it’s backed by the state and non-profits, it’s one of the least expensive types of reverse mortgages. As such, the interest rate and fees are lower. The downside of this mortgage is that it’s not available in every state, so you will need to confirm whether it’s available in your state. Alternatively, talk to your financial advisor, as they will have more information on the states where you can find this type of reverse mortgage.
Home Equity Conversion Mortgage (HECMs)
HECM reverse mortgage is one of the most popular types of reverse mortgage because there are no restrictions on how the money can be used, no income limits, and no medical requirements. However, it’s likely to be more expensive as it has high closing costs compared to a traditional mortgage. It is federally insured (FDA) and managed by the Department of Housing and Urban Development (HUD).
Proprietary reverse mortgages
Proprietary reverse mortgage is backed by private lenders and are ideal for a homeowner looking for more money. To be eligible for this kind of mortgage, your property must have a high value, and have the resources to continue paying taxes, homeowner insurance and any other fees.
This reverse mortgage type does not have an up-front cost or a monthly mortgage insurance premium since it is not federally insured. Since there are no upfront costs, you can borrow more and if your home value is above the set federal limit you can access more cash.
Pros of reverse mortgages
Reverse mortgages have the following main advantages:
- No monthly payments
- Your credit score doesn’t matter as much*
- * = lenders do run your credit and use when checking if you qualify but it’s not nearly as important of a requirement than if you went with a home equity loan.
- You can receive the funds in a lump sum, monthly payments, as a line of credit or a combination of line of credit and monthly payments.
- You get the money to cater to your retirement expenses and you don’t need to move out of your home.
Cons of reverse mortgages
- Costs such as financial assessment fees and monthly servicing fees, which are added to your balance, may add up. Plus, you must continue paying property taxes, homeowner insurance, and maintenance.
- You may outlive your proceeds, leaving you with no alternative, especially if the property is your primary residence at a vulnerable age.
- When you get a reverse mortgage you home will have to be sold to repay the loan. This means your heirs will inherit less or loose the inheritance. They may have to turn the property over to the lender to pay the loan balance or 95% of the appraised home value.
Home equity loans and how they work
A home equity loan, also known as a second mortgage, lets you turn your equity into cash. Home equity loans are called “second mortgages” because you retain your primary mortgage and now start paying two monthly mortgage payments (at different amounts and rates). Unlike the reverse mortgage, which is for people who are 55 years of age and older, a home equity loan is for any homeowner with enough equity built up.
You will receive a lump-sum cash payment and make regular monthly payments to clear off interest and principal. Your home acts as collateral for the home equity loan.
Typically, a home equity loan has a fixed interest rate. This means you will make fixed monthly payments. You will be allowed to borrow a combined loan-to-value ratio (CLTV) of about 80–90% of the property value.
It’s important to note that the amount you can borrow, and the interest rate depend on your credit and payment history.
Pros of home equity loans
- Provide the borrower with an easy source of cash.
- Fixed interest rates make it easy for a borrower to organize their finances.
- Lower interest rate compared with other loans and credit cards
Cons of home equity loans
- You may erode equity in your home if you receive a lump sum and fail to make good use of it.
- Risk of foreclosing if the home’s value decreases and you are unable to pay your loans
- You may take on more debt than you can manage.
Home Equity Line of Credit (HELOC) & how it works
HELOCs are revolving funds you can access using the equity in your home. Many financial experts compare them to credit cards because it’s a line of credit you can access as you choose, and you only pay interest on the amount you borrow. They have a variable interest rate, and you access the money as you pay the debts you owe. There is no interest charged on the unused funds.
What is the difference between a reverse mortgage & home equity loan?
Reverse mortgages and home equity loans are both ways that you can use to get cash from the equity you have built up. However, there are some key differences between the two products. We look at the main differences between the two.
When reviewing your home equity loan application, the lender will look at your credit score, credit history, debt-to-income ratio, and assets.
Lenders who offer reverse mortgages consider your income, age, and credit history.
Home equity loans have a maturity period of between 5 to 30 years, while reverse mortgages mature when the borrower dies or leaves the home.
At maturity, the balance for the home loan equity is zero, while the reverse mortgage is the principal plus interest.
Borrowers with home equity loans and HELOCs must make regular, equal monthly payments to cover the principal and interest. In contrast, borrowers with reverse mortgages don’t have to make regular loan payments. The loan, in this case, is repaid when the property is sold.
In the case of a home equity loan, the lender will consider the primary and second mortgages. The amount the borrower can access is calculated as a combined loan-to-value (CLTV). This will be given by adding the current mortgage plus the equity balance remaining after the first mortgage, divided by the appraisal value.
Most lenders look for a CLTV of 80% to give the borrower a home equity loan.
When it comes to reverse mortgages, the loan-to-value limit is calculated based on the age of the youngest borrower, the interest rate, balance on the current and the value of the home. The LTV for a reverse mortgage is referred to as the “principal limit.”
For example, home equity conversion mortgages (HECMs) have a limit of $970,800 as of 2023.
You don’t need mortgage insurance if you opt for a home equity loan, while HECM requires mortgage insurance. The insurance protects the borrower if the bank fails to make the payments, or the home is sold for less than the mortgage balance. As per the housing urban development if you opt for HECM you need to pay a 2% premium and 0.5% of the loan balance annually.
Borrowers who opt for a home equity loan will receive a lump-sum payment. Reverse mortgages have several disbursement options, including lump sum, monthly payments, a line of credit, or a combination of these.
Age and equity
To qualify for a reverse mortgage, you must be 55 years of age or older. Home equity loans have no age limit.
Credit and income requirements
Reverse mortgages have no income requirements, but you may need to have a minimum credit score. On the other hand, if you take a home equity loan or HELOC you need to have the approved credit limit and proof of income.
Interest paid on reverse mortgages have no tax advantages, while home equity loans’ interest is tax deductible if you spend the money for purposes that qualify. These purposes include buying, building, or improving your home. With that said, the tax advantage with a reverse mortgage is that you are not taxed on the money you receive from the lender.
Due to the nature of reverse mortgages and the complications that may arise, the Federal Housing Administration requires the borrower to attend counseling sessions. The borrower must attend the session before the lender approves the loan. The sessions cover the following:
- Responsibility of a borrower when they opt for a reverse mortgage.
- Features of the reverse mortgage and the cost to incur.
- Tax implications of this type of mortgage.
- Alternatives of a reverse mortgage.
Whichever home loan type you decide to take make sure you can afford to pay the monthly mortgage payments. Here is a summary of the differences to help you make an informed decision.
Reverse mortgage vs. home equity loans: What is the best option for you?
Well, if you are 62 years of age or older and you want to take extra money out of your house to cater for living expenses without selling it or moving, then a reverse mortgage might be the better option. On the other hand, a home equity loan might be a better choice if you would like to keep your home but need extra money for other purposes (like using home equity to consolidate debt) and can afford monthly payments.
Have any questions on reverse mortgages vs. home equity loans? Let us know in the comments section.