If you are a homeowner and at least 62 years old, you may be able to convert your home equity into cash to pay for living expenses, healthcare costs, a home remodel, or whatever else you need. Two options for doing so are reverse mortgages and home-equity loans. Both allow you to tap into your home equity without the need to sell or move out of your home. These are different loan products, however, and it pays to understand your options so you can decide which is better for you.
Most home purchases are made with a regular, or forward, mortgage. With a regular mortgage, you borrow money from a lender and make monthly payments to pay down principal and interest. Over time your debt decreases as your equity increases. When the mortgage is paid in full, you have full equity and own the home outright.
How a Reverse Mortage Works
A reverse mortgage works differently: Instead of making payments to a lender, a lender makes payments to you, based on a percentage of your home’s value. Over time your debt increases—as payments are made to you and interest accrues—and your equity decreases as the lender purchases more and more of the equity. You continue to hold title to your home, but as soon as you move out of the home for more than a year, sell it or pass away—or become delinquent on your property taxes and/or insurance or the home falls into disrepair—the loan becomes due. The lender sells the home to recover the money that was paid out to you (as well as fees). Any equity left in the home goes to you or your heirs.
Note that if both spouses have their name on the mortgage, the bank cannot sell the house until the surviving spouse dies—or the tax, repair, insurance, moving or selling-the-house situations listed above occur. Couples should investigate the surviving-spouse issue carefully before agreeing to a reverse mortgage. The interest charged on a reverse mortgage generally accumulates until the mortgage is terminated, at which time the borrower(s) or their heirs may or may not be able to deduct it
(For more, see Reverse Mortgage Pitfalls).
A type of home-equity loan is the home-equity line of credit (HELOC). Like a reverse mortgage, a home-equity loan lets you convert your home equity into cash. It works the same way as your primary mortgage—in fact, a home-equity loan is also called a second mortgage. You receive the loan as a single lump-sum payment and make regular payments to pay off the principal and interest, which is usually a fixed rate.
With a HELOC you have the option to borrow up to an approved credit limit, on an as-needed basis. With a standard home-equity loan you pay interest on the entire loan amount; with a HELOC you pay interest only on the money you actually withdraw. HELOCs are adjustable loans, so your monthly payment changes as interest rates fluctuate.
Currently, the interest paid on home-equity loans and HELOCs is not tax deductible unless the money was used for home renovations or similar activities. (Before the new 2017 tax law, interest on the home-equity debt was all or partially tax deductible. Note that this change is for tax years 2018 to 2025.) In addition—and this is an important reason to make this choice—with a home-equity loan, your home remains an asset for you and your heirs. It’s important to note, however, that your home acts as collateral, so you risk losing your home to foreclosure if you default on the loan.
Differences Between Loan Types
Reverse mortgages, home-equity loans, and HELOCs all allow you to convert your home equity into cash. However, they vary in terms of disbursement, repayment, age and equity requirements, credit and income requirements, and tax advantages. Based on these factors, we outline the essential differences between the three types of loans:
How You Get Paid
- Reverse Mortgage: Monthly payments, lump-sum payment, line of credit or some combination of these
(see How to Choose a Reverse Mortgage Payment Plan)
- Home-Equity Loan: Lump-sum payment
- HELOC: On an as-needed basis, up to a pre-approved credit limit—comes with a credit/debit card and/or a checkbook so you can withdraw money when needed
- Reverse Mortgage: Deferred repayment—loan due as soon as borrower becomes delinquent on property taxes and/or insurance; the home falls into disrepair; the borrower moves out for more than a year, sells the home, or dies.
- Home-Equity Loan: Monthly payments made over a set amount of time with a fixed interest rate
- HELOC: Monthly payments based on the amount borrowed and the current interest rate
Age and Equity Requirements
- Reverse Mortgage: Must be at least 62 and own the home outright or have a small mortgage balance
- Home-Equity Loan: No age requirement and must have at least 20% equity in the home
- HELOC: No age requirement and must have at least 20% equity in the home
Credit and Income Status
- Reverse Mortgage: No income requirements, but some lenders may check to see if you are capable of making timely and full payments for ongoing property charges—such as property taxes, insurance, homeowners’ association fees, and so on
- Home-Equity Loan: Good credit score and proof of steady income sufficient to meet all financial obligations
- HELOC: Good credit score and proof of steady income sufficient to meet all financial obligations
- Reverse Mortgage: None until the loan terminates; then it depends
- Home-Equity Loan: For tax years 2018 through 2025, interest not deductible unless the money was spent for qualified purposes—to buy, build, or substantially improve the taxpayer’s home that secures the loan (thanks to the Tax Cuts and Jobs Act of 2017)
- HELOC: Same as for a home-equity loan
Choosing the Right Loan for You
Reverse mortgages, home-equity loans, and HELOCs all allow you to convert your home equity into cash. So, how to decide which loan type is right for you?
In general, a reverse mortgage is considered a better choice if you are looking for a long-term income source and don’t mind that your home will not be part of your estate. However, if you are married, be sure that the rights of the surviving spouse are clear.
A home-equity loan or HELOC is considered a better option if you need short-term cash, will be able to make monthly repayments and prefer to keep your home. Both bring considerable risk along with their benefits, so review the options thoroughly before taking either action.
(Also see: Complete Guide to Reverse Mortgage, Comparing Reverse Mortgages vs. Forward Mortgages, Do You Qualify for a Reverse Mortgage?, Reverse Mortgage Types, Picking the Right Reverse Mortgage Lender, How to Choose a Reverse Mortgage Payment Plan, A Guide to Taxes and Reverse Mortgages, 5 Top Alternatives to a Reverse Mortgage, 5 Signs a Reverse Mortgage Is a Good Idea, 5 Signs a Reverse Mortgage Is a Bad Idea, How to Avoid Outliving Your Reverse Mortgage, A look at Regulation of Reverse Mortgages, Rules For Obtaining an FHA Reverse Mortgage, Reverse Mortgage: Could Your Widow(er) Lose the House?, Beware of These Reverse Mortgage Scams, and Reverse Mortgage Pitfalls)