Reverse Mortgage vs. Home Equity Loan: Which Should You Choose?
If you’re 62 or older and you’ve been looking to take some equity out of your home, there are two primary ways to do that – reverse mortgages and home equity loans. Which should you choose? By the time you are done reading this article, you’ll understand the basics of each, and have a better idea of which will best serve your needs.
What is a Reverse Mortgage?
Formally known as a Home Equity Conversion Mortgage (HECM), reverse mortgages are available through the Federal Housing Administration (FHA) and can be obtained from participating lenders. A list of lenders is available through the FHA website.
A reverse mortgage is a unique loan type that allows homeowners to borrow money against their homes, but without the need to make monthly repayments.
But with the absence of monthly repayments, the loan balance will grow over time. This will be the result of equity withdrawals from the home, plus loan servicing costs, plus accrued interest. You should be aware that since you will not be making payments during the loan term, you will not be able to deduct the interest paid on the loan on your income tax return.
Repayment: When the last surviving borrower dies, sells the property, or no longer occupies the home as a primary residence, the loan must be repaid. Also, be aware that this unique repayment scheme does have the potential to deplete your equity in the home. However, neither you nor your heirs will be responsible for covering any loan balance that exceeds the ultimate sale price of the property.
How to Qualify for a Reverse Mortgage
You must meet the following criteria:
- Be at least 62 years old or older.
- Own your home free and clear, or have a considerable amount of home equity available.
- The property must be your principal residence.
- You cannot be delinquent on any federal debts.
- Have the financial ability to make timely payments of property taxes, homeowner’s insurance, and HOA fees, if any. (However, you can choose to have the lender make these payments for you.)
- You must participate in a counseling session with a HECM counselor.
In addition, the property must be either a single-family home, a 2-4 family home (with at least one unit serving as your primary residence), or located in a HUD-approved condominium project.
When you make an application, the lender will verify your income, assets, and monthly living expenses. A credit report will also be run to determine your credit history, but perfect credit is not required. And once the loan is in place, the lender will verify the timely payment of your property taxes, homeowner’s insurance, and flood insurance (if required).
The loan amount will be based on either the appraised value of the property or the HECM FHA mortgage limit (currently $970,800) — whichever is lower.
Like any other type of mortgage, there will be certain costs that must be paid upfront. This will include an origination fee paid to the lender, as well as other closing costs. FHA also assesses a mortgage insurance premium, which will be added to your loan amount. In addition, lenders can add a monthly service fee of $30.
Loan Proceed Options for a Reverse Mortgage
Reverse mortgages are available with five loan proceed disbursement options:
- Single disbursement option: available with a fixed rate loan, but offers less money than other disbursement options.
- Term option: provides a fixed monthly cash payment to you for a specific term.
- Tenue option: provides a fixed monthly cash payment to you for as long as you live in your home.
- Line of credit: allows you to draw down the loan proceeds at your option and in amounts you decide. This option keeps interest charges lower since you only owe interest on the portion outstanding.
- Combination of the above: you can choose a mix of the line of credit and monthly income payments. And for a small fee, you may be able to change your option even after the loan is in place.
You can generally access up to 60% of your initial principal limit in the first year of the loan (at age 62). Otherwise, the lender will calculate the eligible loan amount based on a combination of your age, the value of your home, the applicable interest rate, and an assessment of your financial circumstances.
What is a Home Equity Loan?
A home equity loan is a financing arrangement enabling homeowners to access the equity in their homes. They can be either straight-out loans, with a fixed interest rate, monthly payment, and term, or lines of credit. The latter is referred to as home equity lines of credit or HELOCs. Both types of loans offer the benefit of a relatively low-interest rate since it is collateralized by your home.
Home equity loans and HELOCs are typically provided by banks and credit unions. In a standard arrangement, the lender will provide the borrower up to 80% of the value of their home, less any outstanding existing financing arrangements, like a first mortgage.
For example, if your home is worth $400,000, and you currently have a $200,000 first mortgage against it, a bank or credit union will offer you a home equity loan of up to $120,000.
This is calculated as the value of the home ($400,000) X 80%, equals $320,000, less $200,000 existing first mortgage.
Some lenders will go as high as 85% of the home’s value, and a few may go as high as 90%. Even so, the lender may cap the total amount you can borrow at a fixed amount, like $50,000, $75,000, or $100,000.
If you take a home equity loan, you’ll receive the entire loan proceeds after closing. And unlike reverse mortgages, there are no age limits with home equity loans or HELOCs.
With a HELOC, you’ll be given a line of credit against your home – similar to a credit card line – which you can access any time you need the funds.
Your repayment will be based on the amount of the credit line outstanding. It’s very common for HELOCs to offer an interest-only period for the first few years, followed by a fixed payment term to completely repay the loan. When the loan goes into fully amortizing repayment, you’ll no longer be able to access funds from the credit line.
You should also know that HELOCs typically come with variable interest rates that will adjust with the bank’s prime rate.
Home Equity Loan/HELOC General Terms
Loan terms can range between five years and 20 years. To keep the monthly payments low, some loan arrangements will set up a balloon payment provision. For example, though you may make payments based on a 20-year loan, the remaining balance must be fully paid at the end of the 15th year.
In addition to having sufficient home equity, you’ll need to fully credit qualify for a loan. The lender will verify you have a sufficient, stable income to carry the loan payment (plus the existing first mortgage and any other debt you have), and that your credit score is high enough to meet bank requirements.
HELOCs are typically set up in two parts — a draw phase and a repayment phase.
During the draw phase, you’ll be able to fully access the proceeds of your credit line. You’ll typically make interest-only payments during this time frame. During the draw phase, any loan proceeds you repay will be available to access once again before the draw phase ends.
Key Differences Between Reverse Mortgages & Home Equity Loans
Now that we’ve covered the specific details of both reverse mortgages and home equity loans, let’s summarize the differences between the two:
|Category / Loan Type||Reverse Mortgage||Home Equity Loan / HELOC|
|Age Limit||62 and up||No limit|
|Proceeds Availability||Lump sum, specified timeframe, lifetime payments||Lump sum for loan, revolving access for HELOCs|
|Repayment||Not required||Fixed payments for loans, variable rate and payments for HELOCs|
|Loan Amount||60% of home value, less existing indebtedness; percentage rises with age, maximum loan amount $970,800||80 – 85% of home value, less existing indebtedness|
|Income Qualification||Ability to pay property taxes and insurance only||Fully required|
|Credit Qualification||Not a major consideration||Fully required|
|Closing Costs||2% origination fee, plus normal closing costs and monthly service fee||Generally no more than a few hundred dollars|
|Where to Apply||FHA approved lenders||Banks and credit unions|
Reasons for Taking Out a Reverse Mortgage or Home Equity Loan
If you are under 62 and looking to access the equity in your home, a home equity loan or HELOC will be the best way to do this. Not only is the application process quick, but closing costs are low, and it avoids the need to do a full refinance on your home.
A home equity loan or HELOC is a good idea if you’re looking to cover major expenses, like home renovations, or simply want a line of credit available in case funds are ever needed.
A reverse mortgage should be a consideration only if you are at least 62 years old, and you have substantial equity in your home. The loan is designed primarily for those who lack sufficient income to maintain living in the home, but who don’t want to move.
A reverse mortgage also has the advantage of receiving either a lump sum of cash, or monthly payments for a specific period of time, or even for the rest of your life. That means you can use your home as a source of income during your retirement years.
Considerations When Taking a Reverse Mortgage or Home Equity Loan
Both reverse mortgages and home equity loans reduce your home equity. That effectively puts your home at greater risk.
In the case of a home equity loan or a HELOC, the loan arrangement will also reduce the amount of proceeds you’ll have available from the sale of your home, should you decide to sell. And if property values in your area decline, you can potentially be looking at a negative equity situation.
Reverse mortgages are non-recourse loans, which means the lender cannot come after you for a deficiency if the property doesn’t sell for enough to fully pay off the loan.
You should also be aware that principal, interest, and fees are being added to the reverse mortgage balance on a continuous basis. It’s possible you could reach a point where there is no more equity to access from the home. That would put you back to where you were when you first took the loan – and maybe worse because the equity will be gone.
Be aware that you can face foreclosure with a reverse mortgage. If you don’t make property tax and insurance payments, or you fail to maintain the property in satisfactory condition, the lender can foreclose.
In addition, if you have to transfer to a nursing home and will not be living in your home for 12 months or more, the lender can call in your loan. At that point, the property will either need to be sold or the lender will foreclose.
Generally, no. That’s because it’s a return of equity on your home, not income. That said, there may be certain rare circumstances where taxes could enter the picture. Be sure to consult with your tax professional before signing up for a reverse mortgage.
Yes. Either you or another party can pay off a reverse mortgage at any time. And if the loan is under the FHA program – which most are – there will be no prepayment penalty.
The interest rate on reverse mortgages fluctuates continuously, based on market factors. According to the popular mortgage industry rate source HSH.com, the latest interest rates are 3.46% on a fixed-rate loan, and 2.91% for an adjustable-rate mortgage.