Home Equity Loans: Comparing Your Options

Home equity loans vs reverse mortgages

Generally speaking, a reverse mortgage works better as a steady, long-term source of income, whereas a home equity loan is best if you need a lump sum of short-term cash that you can repay. Both are loans that convert your home equity into cash, but they do so in different ways.

What is a Reverse Mortgage and how do they work?

A reverse mortgage works in the opposite way as a regular mortgage. Instead of making payments to a lender, the lender makes payments to you, based on a percentage of your home’s equity. Over time, this means your debt increases as your equity decreases.

Though you continue to hold the title to your home, if you become delinquent on your property taxes or your insurance, the home falls into disrepair, you move, sell it or pass away—the loan automatically becomes due. If any of these scenarios occur, the lender will sell the home to recover the money that was paid out to you, as well as any associated fees, and any remaining equity goes to you or your heirs. If both spouses names are on the mortgage, the bank cannot sell the house until the surviving spouse passes away, or any of the other aforementioned scenarios occur.

To qualify for a reverse mortgage, the following requirements must be met:

the borrower must be 62 or older
the borrower must own their home outright or have a low enough mortgage balance that it can be paid off from the proceed of the reverse mortgage
the borrower's home must be their primary residence
the borrower must have the financial resources to continue paying mandatory obligations such as homeowner’s insurance, and property taxes, or can do so with funds from the reverse mortgage

Types of Reverse Mortgages

Finally, when considering a reverse mortgage, you should be aware that there are two types, and each will affect the amount of cash you’ll receive.

1. Adjustable Rate reverse mortgage

The first is the Adjustable Rate reverse mortgage loan, in which the borrower must put all of the funds available after the payoff into a lump sum, a line of credit, or monthly payments, also known as a tenure. The interest rate will vary according to the United States Treasury rate (CMT), but in Home Equity Conversion Mortgages (HECM), the adjustable rate cannot grow over a cap amount based on the initial rate. The advantage to the credit line is that you only pay interest on the funds you withdraw, not on the total available to you. And the remaining money in the line of credit earns interest while you don’t use it.

2. Fixed Rate reverse mortgage

With a fixed rate loan, you receive one rate for the entire period of the loan, and requires that you receive all of the loan proceeds in one lump sum at the time of closing.

Pros and Cons of a Reverse Mortgage

Financial advisors generally agree that tapping into your home equity should be a measure of last resort. If you need extra money to cover your living expenses, check if you qualify for a state or local program to lower your expenses. You might also consider whether downsizing to a less expensive home may be an option.

However, a reverse mortgage can be an ideal solution if you’ll get enough funds to solve your financial plans in the long term, you’ve no plans to move or leave your house to anybody, and can afford to pay the property taxes, homeowners insurance and home maintenance. Another worthwhile benefit of a reverse mortgage is that it allows you to delay filing for Social Security until you’re 65 or 70, in order to get a bigger benefit.

PROS of a Reverse Mortgage

Choose how the cash is paid out to you, whether as a lump sum, monthly advance, or line of credit.
If you outlive the loan (receive more payments than the house is worth), you won’t owe more than its value.
No required minimum income.
Maintain the title to your home.
If you have a Home Equity Conversion Mortgage (HECM), you can live in a nursing home for up to 12 months before the loan becomes due.

CONS of a Reverse Mortgage

May impact your eligibility for Medicaid or Supplemental Security Income.
Uses the equity in your home, leaving you and your heirs with fewer assets.
High Costs: Counseling fees, appraisal fee, origination fees, upfront costs, and ongoing ones as well, such as a monthly servicing fee.
If you fail to pay taxes, homeowner’s insurance or other expenses, the loan can become due.
Your debt increases over time, as the interest is added to the loan balance.

Other options

Home equity loans

A home equity loan is a second mortgage that uses the accumulated equity in your home as collateral. Once your property is appraised, the loan amount is issued as a lump sum based on its estimated value. Just as you would with a first mortgage, you then make monthly payments on the principal and interest.

The size and interest rate of your home equity loan will depend on your credit score, employment and payment history, and your home’s appraised value, but the maximum amount you can borrow is usually limited to 85 percent of the equity in your home. Though there is no age requirement, it's recommended that you own at least 20 percent of your home in order to qualify.

Generally speaking, since you are actively repaying the debt, a home equity loan is a good choice for those who need short term access to cash and intend to retain ownership of their house to pass to their family or heirs. There is no age requirement, but to qualify you generally need steady employment and a good credit history. Just as with a first mortgage, each of these elements will also factor into the amount and interest rate you’re approved for.

PROS of a Home Equity Loan

Lump sum for a large amount that can be used for anything you want.
Lump sum for a large amount that can be used for anything you want.
Tax-deductible interest on the first $100,000 borrowed.
Often have lower interest rates than other types of debt.
Predictable payments with fixed interest rates.
Can be used for debt consolidation, at a lower interest rate.

CONS of a Home Equity Loan

Risk of foreclosure if you stop making payments, as you’ve put your house on the line.
Costs can rise quickly, between credit checks, appraisals and origination fees.
Interest costs are still costs, and are generally slightly higher than for first mortgages.
Feeds the cycle of debt. Essentially, you’re borrowing in order to spend, and the spending habit can immerse you in debt.
You may have to take out a larger loan than you need, as most lenders have minimum amounts of between $15,000-$25,000.
HELOCs are similar to both home equity loans and reverse mortgages in that they also convert the equity in your home into readily available cash. A HELOC, however, has different characteristics.

Home equity line of credit (HELOC)

Their terms are more open-ended, they’re subject to variable interest rates, and once you’re approved for a total loan amount, instead of getting a lump sum, you withdraw money when needed. Some lenders, however, will allow you to convert all or part of the sum you’ve borrowed into a fixed rate loan at the market’s current interest rate.

HELOCs are divided into the draw period, during which you can withdraw on the credit line, and the subsequent repayment period, when you pay back the money you’ve received. During the draw period, you’re only required to make interest payments, whereas once the repayment period begins, payments are made on both the interest and the primary.

PROS of a HELOC

Flexibility- since you can draw on the credit line whenever you want during the draw period, it can be used much like a credit card, and paid off monthly.
Interest rates are variable, meaning they fluctuate according to a benchmark, generally the prime rate set by the Federal Reserve.
During the draw period, only pay the interest on what you borrow.
Can offer the option of converting to a fixed rate loan, if rates get low.
Tax-deductible interest up to $100,000.
You can simultaneously consolidate high-interest debt and improve your credit score by making timely payments on your HELOC.

CONS of a HELOC

Some lenders structure their HELOCs with balloon payments at the end of the draw period, in which you must pay the total sum you’ve borrowed.
If your home declines in value, you might owe more on your HELOC and first mortgage combined than your house is worth.
Lenders can cancel your credit line at their discretion. For example, if your home falls in value, or you lose your job.
Possible foreclosure if you default on your payments.

Cash-out refinance

A cash-out refinance is when a homeowner replaces their current mortgage with a new loan for more than the amount owed, and takes the difference in cash. The interest rates on cash-out refinances are usually lower than for home equity loans or HELOCs.

Cash-out refinance rates are some of the most competitive in the industry, and this option can make sense if you get a good rate on the new loan, and have a good use for the money, such as debt consolidation or home repairs. Using the cash payout for something like a vacation or the purchase of a new car is a bad idea, as these offer little to no return on your investment. As with all of the other option we’ve discussed here, it’s important to remember that you’re using your home as collateral, so it’s essential that you make your payments in full and in a timely fashion.

PROS of a Cash-out Refinance

Lump-sum cash payment at closing.
Possibly refinance your mortgage at lower interest rates than a home equity loan or HELOC. The rates can be fixed or variable.
Can help you consolidate high-interest debt with the cash payout, and improve your credit score.
Mortgage interest rates are tax-deductible.
Qualifying is typically easier than for a first mortgage.

CONS of a Cash-out Refinance

Closing costs can amount to thousands of dollars, as they’re typically three to six percent of the mortgage.
Since you’re effectively “re-setting” the terms of your current mortgage, unless the refi is for a lower number of years, you may also extend your repayment term.
Using your home as collateral puts you at risk for foreclosure if you default on your payments.
If you borrow more than 80 percent of your home’s value, you may have to pay for private mortgage insurance.
Since you’re refinancing for a larger amount than you current mortgage, your mortgage amount per month will be higher. This issue is compounded if your home’s value falls.

FULL COMPARISON

	Reverse Mortgage	Home Equity Loan	HELOC	Cash-out Refinance
Payment Disbursal	Monthly payments, credit line, or lump sum	Lump sum	Credit line, allows large withdrawals of lump sums	Lump sum
Repayment	Deferred repayment	Monthly payments with fixed rate	Monthly payments with variable rate, option to convert to fixed rate loan.	Monthly payments
Requirements	62+ years old, home appraisal, occupancy requirements, no income requirements, but you must remain current on taxes, insurance and property condition.	No age requirement, home appraisal, credit score, payment history, debt-to-income ratio, at least 20% equity.	No age requirement, home appraisal, credit score, payment history, debt-to-income ratio, at least 20% equity.	No age requirement, home appraisal, credit score, payment history, debt-to-income ratio, time in residence
Costs and fees	Counseling fees, appraisal fee, origination fees, upfront costs, and ongoing ones as well, such as a monthly servicing fee.	Closing costs, possibly paying points, appraisal, application fee, points, and annual maintenance fee.	Possible origination fees, low closing costs, annual fee, cancellation fee, possible transaction and inactivity fees.	Origination fees, closing fees, appraisal, possibly private mortgage insurance.
Tax advantages	Payments made out to you aren’t taxable, but the interest accrued isn’t deductible until you actually pay off the mortgage.	Generally tax-deductible interest for loans up to $100,000	Generally tax-deductible interest for loans up to $100,000	Generally tax-deductible up to $100,000

What to consider when making a decision

If you’re over 62, and have accumulated a good amount of equity in your home but are cash-poor, it may be a smart financial decision to convert that equity into funds to pay for living expenses, healthcare, a home remodel or whatever else you need.

The main points you should consider before choosing between a reverse mortgage, home equity loan, HELOC or cash-out refinance are:

The amount of equity you have
The amount you need to borrow
The type of repayment plan that best works for you
Whether you’d prefer a fixed or flexible term
The interest rate and term on your current mortgage
Whether you wish to leave your house to your heirs

All four of the options we’ve evaluated allow you to convert your home equity into cash, but they differ differ in how it’s paid out, repaid, the age and equity requirements, credit and income requirements, and their different tax advantages.

A reverse mortgage is considered a better choice when looking for a long-term income source and aren’t worried that your home won’t be part of your estate. One of its advantages is that your credit isn’t as important as with other types of loans, but they do generally have higher origination costs in comparison.

A home-equity loan or HELOC are more advantageous if you need short-term cash, have the ability to make monthly payments, and prefer to keep your home. However, they do incur fees that other loans do not, such as appraisal fees, closing costs and title searches.

Cash-out refinances can be a great choice to consolidate high-interest debt, obtain some immediate cash and simultaneously lower your mortgage term. However, if you’re only looking to lock in a lower interest rate and don’t need the cash, a regular refinance makes more sound financial sense.

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Reverse Mortgage vs a Home Equity Loan: Weighing Your Options