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.
- Unlike a first mortgage, where you make monthly payments to the lender, with a reverse mortgage the lender pays you.
- Eventually, a reverse mortgage lender sells the home to recover monies paid out to the homeowner, with any remaining equity going to them or their heirs.
- A home equity loan involves a single lump-sum payment that is repaid in regular installments to cover the principal and interest (which is usually at a fixed rate).
- Like credit cards, HELOCs let you draw on your line of credit when you need it and only pay interest on what you use.
- All three loans have advantages and disadvantages that homeowners need to take into consideration to determine which one is right for them.
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 Mortgage Works
A reverse mortgage works differently: Instead of you making payments to a lender, the 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 it. 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.
Study carefully the six types of reverse mortgage and make sure you choose the one that works best for your needs. Scrutinize the fine print—with the help of an attorney or tax advisor, if possible—before you sign on.
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; there have been problems, especially if one spouse is significantly younger, perhaps too young to have signed on to a reverse mortgage when it was established. There can be other drawbacks, too, including high closing costs and the possibility that your children may not inherit the family home. 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.
How Home Equity Loans and HELOCS Work
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. And you don't have to be 62 to get one.
With a HELOC you have the option to borrow up to an approved credit limit, on an as-needed basis. In that regard, a HELOC functions more like a credit card. 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 usually adjustable loans, so your monthly payment changes as interest rates fluctuate.
The fixed interest rate on a home equity loan means you always know what your payment will be, while the variable rate on a HELOC means the payment amount is changeable.
Currently, the interest you pay on home equity loans and HELOCs is not tax deductible unless you use the money for home renovations or similar activities on the residence that secures the loans. (Before the Tax Cuts and Jobs Act of 2017, interest on 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 Among 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 among the three types of loans.
How You Get Paid
- Reverse Mortgage: Monthly payments, lump-sum payment, line of credit or some combination of these
- 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 is due as soon as borrower becomes delinquent on property taxes and/or insurance; the home falls into disrepair; or 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; must own the home outright or have a small mortgage balance
- Home Equity Loan: No age requirement; must have at least 20% equity in the home
- HELOC: No age requirement; must have at least 20% equity in the home
Credit and Income Status
- Reverse Mortgage: No income requirements, but some lenders may check that you can make timely and full payments for ongoing property charges, such as property taxes, insurance, homeowners’ association fees, et al
- 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 only deductible if the money was spent for qualified purposes—to buy, build, or substantially improve the taxpayer’s home that secures the loan
- 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.
Either a home equity loan or a 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.