Homeownership provides many perks, ranging from more stability and better tax deductions. The major perk attracting many homeowners is the promise of escaping rent payments. After paying off your mortgage, your cost of living will become more manageable. If you follow the 28% rule, more than a quarter of your budget will go towards the mortgage. You will have all of that money freed up after paying off your home debt.
While some people dream of becoming debt-free, other homeowners occasionally access home equity for various expenses. In addition, some people borrow against their home equity to cover emergency expenses or living expenses as they get older. Reverse mortgages and home equity loans are two popular financial products that help borrowers unlock their home equity. Taking a closer look at each loan option will help you decide which one is right for you.
How Does a Reverse Mortgage Work?
A reverse mortgage is for borrowers who want monthly payments as if they were the bank. You can either receive monthly payments or a lump sum based on your available home equity. You do not have to repay a reverse mortgage right away and can continue borrowing against your home equity. You will only have to repay the reverse mortgage after you sell your home or move out; otherwise, your estate will be repaid after your death. Throughout the reverse mortgage’s duration, interest will continue to grow. Most people use reverse mortgages after they retire and need an extra income source.
How Does a Home Equity Loan Work?
A home equity loan lets you borrow a lump sum payout from your home equity. Borrowers have to make fixed monthly payments towards the home equity loan right away. You cannot borrow more than 85% of your home’s value between a home equity loan and your mortgage. Some people refer to home equity loans as second mortgages since these loans do not replace the original mortgage. You would have to get a refinance to replace your current mortgage.
Reverse Mortgage vs. Home Equity Loan: Key Differences
Both financial products let you tap into your home equity. However, the mechanics behind them impact how much you can pay in the long term.
Fund Disbursement
Home equity loans always provide a lump sum payment. You can also get all of the proceeds at once with a reverse mortgage, but you can choose to receive monthly payouts instead. This is because receiving some of your home equity each month from a reverse mortgage delays interest compounding. At the same time, you already owe interest on all of the proceeds of the home equity loan.
Loan Repayment
Home equity loans have fixed monthly payments. You can work them into your budget and extend the loan’s term if you need lower monthly payments. Home equity loans have 5-20-year terms. You do not have to repay a reverse mortgage until you sell, move out, or pass the property to one of your heirs. Reverse mortgages put less financial stress on you at the moment, but accumulating interest can eat into your remaining home equity if it snowballs too much.
Required Age and Equity
A home equity lender requires the applicant to be 18 years or older, and most lenders will not let you borrow more than 85% of your home’s equity between a home equity loan and a first mortgage. Reverse mortgages have more flexibility, but you have to be 62 years or older to qualify. Most people use reverse mortgages to fund their retirements.
Credit and Income Requirements
Applicants usually need a debt-to-income ratio below 43% to qualify for a home equity loan, and you will need a 620 credit score or higher in most cases. A reverse mortgage does not have any credit or income requirements. You do not even have to supply the lender with information about your income or credit since lenders know they will receive the proceeds after your home sale.
Tax Advantages
Home equity loans can provide tax advantages if you use the proceeds to buy, build, or improve a home. You can deduct interest payments under this scenario. Reverse mortgages do not provide tax deductions, but the proceeds are not taxable. The IRS treats these payouts as loan proceeds rather than income. You get to keep all of the money you accrue from a reverse mortgage, which means you won’t have to worry about the government dipping its hands into your reverse mortgage payouts.
Loan Amount
The maximum loan amount for a home equity loan is based on your LTV ratio. This ratio measures your property’s debt as a percentage of its value. If you have an $800,000 mortgage and a $1 million property, you have an 80% LTV ratio. Some banks limit you to an 80% LTV ratio, while others let you stretch as high as 95% LTV. You cannot borrow money equal to your entire equity position if you opt for a home equity loan.
A reverse mortgage is the best option for borrowing your entire home equity position. Home equity conversion mortgages distribute monthly payments until you use up your home equity. Older homeowners won’t have to repay the loan during their lifetimes as long as they keep the property in good condition and pay property taxes.
Interest Rates
A home equity loan typically has a fixed rate, while a home equity line of credit usually has a variable rate. Reverse mortgages offer fixed and variable rates, but fixed rates are the better option for more consistency. Variable rates create less predictability for how quickly the loan balance for your primary residence can accumulate.
Pros and Cons of Reverse Mortgages
Pros:
- Reverse mortgage payouts help you fund your retirement years
- You don’t have to worry about making monthly payments
- Payouts are not subject to taxation
- If one spouse dies, the other can still collect reverse mortgage payouts instead of being forced to pay it back
- You won’t have to sell your home since you can live on reverse mortgage payments
- Borrowers get to choose the frequency and amount of reverse mortgage payments
Cons:
- You may outlive your reverse mortgage payouts.
- Compounding interest may leave you with little remaining equity when it’s time to sell.
- Reverse mortgages have higher interest rates than home equity loans since lenders have to wait longer to receive their payout.
- Your heirs may not receive many proceeds when you pass away since the estate must first repay the lender.
- It’s possible to default on a reverse mortgage. The lender can call it in for several reasons, including if your home deteriorates over time.
- Lenders may force you to close lines of credit on your home.
Pros and Cons of Home Equity Loans
Pros:
- Fixed monthly payments make it easier to predictably fit loan payments into your budget.
- Lower interest rates
- You can pay the loan over 5-20 years, resulting in lower monthly payments.
- Low closing costs
Cons:
- You need good credit to get more equity and better terms.
- Interest will accumulate on your loan.
- You must generate enough income and have a sufficient debt-to-income ratio.
- The borrower must ask for another home equity loan and repeat the process if the proceeds from the first loan are insufficient.
Factors to Consider: Reverse Mortgage vs. Home Equity Loan
These are some of the details to keep in mind before you choose one of these loans.
Evaluating Your Retirement Goals
Your home equity can get you closer to your retirement goals, but you also have to consider if you want to regain the home equity that you gave up. Reverse mortgages are primarily for homeowners who want a fixed income and don’t plan to work anymore.
You don’t have to repay a reverse mortgage loan while you are alive unless you no longer qualify for the loan. It’s the better choice for retirees who want to tap into all of their equity over time.
A home equity loan is an alternative if you want to make monthly mortgage payments to recoup your equity. Some people take out home equity loans to cover significant expenses like medical bills, but they want their heirs to have more equity in the property. This type of loan usually has a fixed interest rate, which makes monthly payments more predictable.
Assessing Your Financial Situation
Your specific needs play a big role in determining the best choice for accessing equity. A home equity loan acts as a second mortgage, which will increase your monthly payments; however, if you don’t have much money to keep up with regular monthly payments, a reverse mortgage can offer financial relief.
Depending on your situation, you may also want to consider other popular options like a cash-out refinance or a HELOC. A home equity investment is another alternative that doesn’t involve taking out a loan.
A home equity loan may be the better choice if you are still making money and do not plan on retiring. It’s also the better choice in most cases if you are making home improvements. HECMs are usually for people who want to retire and stay in their current home. Knowing the nuances of your financial situation and your loan options can lead to a more informed decision.
Understanding the Risks and Responsibilities
Each home loan comes with risks. A home equity loan leads to higher monthly payments, while a reverse mortgage stops your mortgage payments and allows you to receive monthly distributions. A reverse mortgage combined with Social Security income can lead to a solid retirement. However, you run the risk of burning through your home equity if you use a reverse mortgage.
Home equity loans require that you still make monthly payments and regain equity in your home. While the extra monthly mortgage payment can increase your financial stress, it can be worth it in the long run. You will have equity in your home that you can tap into if necessary, and you can also pass on more capital to your heirs.
When to Use a Reverse Mortgage
A reverse mortgage is an optimal choice if you have a lot of equity built into your home and have already retired. The reverse mortgage acts as a non-taxable income source, allowing you to benefit from the years of equity you built into your home. You can continue living on your property and won’t have to move anytime soon. You must be at least 62 years or older to apply for a reverse mortgage.
When to Use a Home Equity Loan
If you are younger than 62 years old, you will have to opt for a home equity loan. Borrowers who can select either loan will benefit from a home equity loan if they are not yet retired. Home equity loans have fixed monthly payments and lower interest rates. You can get the cash you need and rebuild your equity with monthly payments. You should only take out a reverse mortgage when you’re ready to retire and ride off into the sunset. You don’t want to run the risk of outliving your reverse mortgage. Prolonging a reverse mortgage and using a home equity loan instead can help.
Conclusion: Reverse Mortgage vs. Home Equity Loan
Tapping into the equity of your home can be a good idea for many people. The extra funds can help with home repairs, medical expenses, and other costs. Both of these loans have options for variable interest rates and fixed interest rates, so you will have plenty of choices.
The choice boils down to your age and your financial goals. If you are younger than 62 years old, you will have to take out a home equity loan. However, an HECM reverse mortgage is in play if you are 62 years or older and have a sizable equity position in your home. HECMs also only apply to your primary residence, so you have to use a home equity loan for a real estate investment.
Reverse mortgages are more suitable for older adults who want to retire, trim their monthly payments, and live off of Social Security and cash flow from their investments. Home equity loans are typically the better financing option if you still plan on working and want to regain equity in your property.
