Reverse Mortgage Vs. Home Equity Loan Or HELOC: The Difference And How To Choose

Homeownership is one of the most complex, expensive investments you can make – but one of the primary benefits is the ability to use equity. A financially powerful force, equity is the cash value in your home that increases as you pay your mortgage.

Whether you have a young family in a newer home or are retiring, equity can help you afford bigger expenses and make upgrades to your house. While older homeowners have exclusive access to reverse mortgages, any homeowner with sufficient equity can take out a home equity loan. But which is right for your goals? The following is a closer look at the reverse mortgage versus a home equity loan and how to tell which is the better option for you.

As we talk about each loan, keep in mind that not all lenders provide these products. For example, our sister company, Rocket Mortgage^®, does not offer reverse mortgages or home equity lines of credit (HELOCs).

A reverse mortgage, home equity loan and HELOC are all options that help homeowners access their home equity. You can calculate home equity by subtracting your mortgage balance from your home’s value. For instance, say you have $200,000 left on your mortgage, and your home is worth $300,000. Therefore, you have $100,000 in home equity to leverage through various financial tools. Each has benefits and drawbacks that fit specific financial situations.

A reverse mortgage is a tax-free loan based on home equity and is available to homeowners age 62 and older. You can get a reverse mortgage only on your primary residence. The money first pays off the rest of your mortgage (if you have one), then the rest of the money comes to you. You’ll no longer have to make monthly mortgage payments on the home, but property taxes, homeowners insurance and home maintenance will still be your responsibility.

You don’t have to repay the loan until you sell the home, change your primary residence or pass away. When any of these conditions occur, the reverse mortgage balance plus interest is due to your lender.

There are three types of reverse mortgage: home equity conversion mortgage (HECM), single-purpose reverse mortgage and proprietary reverse mortgage. HECMs are the most popular type of reverse mortgage because the funds are flexible and they come with protections from the Federal Housing Administration (FHA). With a HECM, you can use the money you receive however you wish, and you can opt for a lump sum payment, monthly installments or a line of credit depending on the type of HECM you get. Plus, thanks to FHA regulations, HECMs are nonrecourse loans. That means you’ll never owe more than your home is worth.

A single-purpose reverse mortgage comes with conditions from your lender to use the funds solely for an approved reason, such as home repairs or tax payments. Access to these loans varies by region and the local organizations offering them. However, they’re generally less expensive than HECMs.

Because the aforementioned reverse mortgages are for loans up to the conforming limit, proprietary reverse mortgages are usually for high-value homes that exceed those limits. They come from private lenders and therefore have less restrictions and regulations than other reverse mortgages.

Pros

Reverse mortgages have the following advantages:

• No monthly payments. Your reverse mortgage balance is only due if you sell your home, move or pass away. Otherwise, you only have to pay your property taxes and homeowners insurance.

• You can stay in your home. A reverse mortgage pays off your mortgage balance and allows you to live in your house.

• No income requirements. You can qualify for a reverse mortgage if you’re struggling financially to help stabilize your circumstances.

• The money is tax-free. As a result, you won’t have to claim your reverse mortgage as income when filing taxes.

• You can target significant life expenses. Specifically, with a HECM, you can use the funds for one or more crucial items, such as home repairs, living expenses, credit card debt or medical bills.

• You won’t leave your heirs in a bind if you have a HECM. If you pass away, your heirs can give the title to the lender and walk away without spending a penny. They can also sell the home to cover the balance due and keep the remaining proceeds. Or, they can refinance the reverse mortgage and start making monthly payments on a new loan.

Cons

If you have a reverse mortgage, you’ll navigate the following drawbacks:

• Your loan balance will increase if you don’t make interest payments. This situation could snowball into a balance higher than your home’s value. If you don’t have a HECM, you’ll need to pay the difference. That could force you or your heirs to give up the home when the balance is due.

• You’ll have to pay origination fees to your lender, closing costs and insurance costs to the FHA (if you have a HECM). While you might be able to roll these charges into your loan, you’ll receive less money from the loan and owe more when the loan is due.

• You can’t deduct mortgage interest on your tax return until you pay off the reverse mortgage.

• The loan could affect Medicaid and Supplement Security Income, so talk to a financial advisor before applying for this loan.

• You can lose your home through foreclosure if you don’t pay property taxes, HOA fees or homeowners insurance or if you fail to maintain your home.

• Your home might lose primary residence status if you have to go into an assisted living facility. Additionally, you might face other challenges, such as adding a spouse to your loan if you marry after receiving the reverse mortgage.

A home equity loan is a lump sum you receive upfront and then repay over a predetermined period of time. Home equity loans let you tap up to 85% of your equity, depending on certain factors, including your lender and credit score. You can use this money any way you like. Unlike a reverse mortgage, where the loan comes due under specific conditions, you repay a home equity loan through monthly installments that begin soon after receiving the loan. As a result, home equity loans are also called second mortgages because you make monthly payments on that loan along with your original mortgage.

Home equity loans can come from equity in your primary or secondary home and have fixed interest rates. This loan type can range in size, from a sum that helps you pay off a high-interest debt to a sum that pays for a home addition.

Pros

You’ll enjoy the following benefits with a home equity loan:

• No limitations on using the money. You can use the lump sum in any way you choose, like making home improvements or affording a child’s college tuition.

• You may qualify for this loan more easily than other loans. Lender requirements for your equity, credit score and debt-to-income ratio are less stringent for home equity loans.

• These loans have lower interest rates than credit cards. Credit cards usually have double-digit interest rates, while home equity loan rates are significantly lower. 

• You’ll have fixed monthly payments. Home equity loans have fixed interest rates, so your monthly payment will remain consistent throughout the life of the loan. This feature allows you to budget for an unchanging loan payment.

• You can access the funds immediately in one lump sum. You can tackle significant expenses sooner with a lump sum instead of monthly installments.

• Your repayment period can be longer than other loans, giving you more time to pay off your balance and lower monthly payments.

Cons

Home equity loans also come with these pitfalls:

• You risk foreclosure if you default on the loan. Like your first mortgage, a home equity loan uses your home as collateral.  

• You’ll have two loans to pay off if you sell your home. As a result, selling your home could put you into a daunting financial position because your home sale might be insufficient to repay your first and second mortgages.  

• You’ll have to pay closing costs. Home equity loan closing costs usually are 2% to 5% of the loan amount. 

A HELOC turns your equity into a financing source you can borrow against and repay over several years. HELOCs have two phases. The first is the draw period, in which you use your equity as you wish. You may have several years to withdraw money and make interest-only payments on amounts borrowed.

The second phase, the repayment period, also lasts several years. You’ll make monthly payments toward the amount owed until your balance is paid. HELOCs can have variable interest rates, meaning the interest changes every month, quarter or year. This can affect your monthly payment. Like a home equity loan, the balance due is also considered a second mortgage.

Pros

A HELOC grants homeowners numerous perks:

• Variable interest rates are initially lower than fixed interest rates before they adjust, making them less expensive in the short term.

• Interest could be tax-deductible if you use the funds for home improvements.

• No closing costs. This feature allows you to access your equity without paying as much up front.

• You can use the money for any purpose.

• You can borrow the exact amount that you need from your line of credit, eliminating the possibility of paying interest on money you don’t use. As a result, you don’t have to worry about a lump sum being too much or too little.

• It could raise your credit score by allowing you to pay high-interest debts and replace them with your HELOC balance.

Cons

Homeowners with HELOCs will also face the following challenges:

• There are several upfront costs and fees, including the application fee, home appraisal, title search and attorney fees.

• Your interest rate could increase. HELOCs usually have variable interest rates, which adjust periodically with the economy. As a result, market dynamics could raise your interest rate and, therefore, your monthly payment. 

• You’re using your home as collateral. If you default on HELOC payments, your lender could foreclose on your house.

• Your spending might spiral out of control. Because you can access a significant chunk of equity through a HELOC, your discipline might run thin and give way to impulse purchases.

Reverse mortgages, home equity loans and HELOCs let you use your home equity. However, they have distinct functions and stipulations crucial for homeowners to understand.

Special Requirements

Reverse mortgages are only available to homeowners age 62 and older who wish to tap equity in their primary residence only. Plus, if you’re getting a HECM, the most common type of reverse mortgage, you’ll have to attend a financial counseling session the Department of Housing and Urban Development (HUD) approves of to complete the application process.

On the other hand, home equity loans and HELOCs have equity requirements for borrowers. Generally, you must have at least 20% equity in your home and can use up to 85% of your equity.

Credit Score And Income 

Reverse mortgages have no income or credit requirements. However, HECMs require a financial assessment to ensure you can uphold the financial obligations of the loan. Conversely, lenders usually require a credit score of 620 or higher and a sufficient income level for borrowers to qualify for a home equity loan or HELOC. If your monthly debt payments cost more than a percentage of your monthly income, you might have trouble getting one. For a home equity loan from Rocket Mortgage, you must have a debt-to-income ratio (DTI) of no more than 45%.

Disbursement

Home equity loans disburse your funds as a lump sum payment. However, homeowners access funds in a HELOC from a line of credit and at will. They borrow money as they see fit during the draw period.

Reverse mortgage disbursement depends on the type. A HECM can provide funds as a single lump sum, monthly installments or a line of credit. Single-purpose reverse mortgages usually come as a lump sum to pay for the approved expense. In addition, lenders disburse proprietary reverse mortgages according to their own stipulations instead of governmental laws.

Repayment 

Repayment for a home equity loan is like your original mortgage: you borrow the money and start repaying the loan through monthly payments. On the opposite end, reverse mortgage balances aren’t due unless the borrower dies, moves or sells the house. If the borrower passes away, heirs are responsible for repayment.

HELOC repayment is unique because borrowers make minimum or interest-only payments during the draw period. When the draw period expires, borrowers make monthly payments on the balance due, similar to a home equity loan. However, monthly payment amounts will vary with the adjustable interest rate.

It’s recommended that every homeowner carefully consider their situation and all relevant factors when deciding between a reverse mortgage, home equity loan and HELOC. Each equity tool has its own implications that can impact a borrower’s financial circumstances. It’s best to speak to a financial professional about your financial situation and goals to help you choose the best option.

When A Reverse Mortgage May Be Best

A reverse mortgage might be best for a senior who needs to supplement their income to live comfortably, doesn’t plan on moving and doesn’t have heirs who wish to inherit the home free and clear. In this scenario, a reverse mortgage can provide thousands of dollars to help with the cost of living, medical expenses, and more while putting the homeowner under less financial obligation.

That said, a homeowner who has heirs or wants to sell their home in the future might still use a reverse mortgage – but additional financial planning is likely necessary.

When A Home Equity Loan May Be Best

A home equity loan might be ideal for homeowners who need to cover a costly expense or home renovation. For instance, a home equity loan can be a cost-effective way to address a high-interest debt balance or a minor home improvement project. Additionally, since home equity loans have lower interest rates than personal loans and credit cards, using a lump sum for one significant expense can be financially advantageous.

When A HELOC May Be Best

A HELOC may be best when you have several expenses to pay for over the next few years that your equity can cover. For example, if you have three home improvement projects you’d like to complete in the next 5 years, a HELOC can allow you to tap your equity for each project in succession.

This decision is better than receiving a lump sum from a home equity loan for two reasons: first, you’d have to start repaying the home equity loan immediately. Secondly, you might borrow the incorrect amount, either running up an excessive balance or needing more financing than you initially thought.

A HELOC is ideal for a homeowner with multiple planned expenses because you can borrow as you go without having to pay up front. Once your projects are done, you enter the repayment period.

Using equity is a powerful financial tool in a homeowner’s arsenal. Three options – the reverse mortgage, home equity loan and HELOC – come with their own distinct advantages and disadvantages. For example, reverse mortgages are only available to homeowners 62 and older, while home equity loans and HELOCs allow more homeowners to use a portion of their equity.

All three options generally let you use the cash in any way you choose. However, because each option has specific conditions, such as variable interest rates or the financial responsibility of heirs, it’s crucial to consider each one carefully before deciding how to access your equity.

If a home equity loan is right for you, start your application with our friends at Rocket Mortgage today.