Owning a home has its benefits—more space, flexibility, and autonomy are just a few. What’s another great asset? Equity. When you have equity in a home, you can borrow against it.
There are several ways to do that—a refinance, a cash-out refinance, a home equity loan, or a home equity line of credit (HELOC) are a few of them. If you’re over the age of 62, you can also take out a reverse mortgage. But which choice is right for you?
We’ll see how two options—a refinance or a reverse mortgage—compare.
- Refinancing allows you to lower your monthly payment while keeping the equity in your home.
- Reverse mortgages pay you monthly, in a lump sum, or in a line of credit.
- Reverse mortgages don’t have to be resolved until you move or pass away.
- Refinancing is generally the cheaper option.
How a Reverse Mortgage Works
As opposed to a traditional mortgage, a reverse mortgage pays you by using the equity that you’ve accrued over years of mortgage payments. Money can be received in a lump sum, a line of credit, or monthly payments. These mortgages are available only to seniors over the age of 62 who have significant equity available—generally around 50%.
There are three types of reverse mortgages: home equity conversion mortgages (HECMs), which are insured by the Federal Housing Administration (FHA); proprietary reverse mortgages, offered by private lenders; and single-purpose reverse mortgages, which are typically offered by state and local governments and nonprofits.
What Is a Refinance?
Refinancing means that you take out a new loan to pay off your old loan. It’s a way for homeowners to access lower rates or lower payments by taking out a new loan to pay for the existing loan. When interest rates are low, refinancing can save significant money over the long run.
Many people also refinance to change the terms of their loan, by switching to either a fixed-rate loan or an adjustable-rate loan. Increasing or decreasing the amount of time on the loan is also possible. Depending on your unique financial situation, these actions may reduce your monthly payment.
Refinancing may not reduce your monthly payments enough to pay for home renovations needed to age in place. If you need significant repairs, consider a cash-out refinance.
Pros of Reverse Mortgages
Many seniors consider reverse mortgages as a way to add cash flow to their monthly budget. If this is the case, then a reverse mortgage has more potential. While a refinance may lower your monthly costs, it may not lower your payment enough to impact your monthly budget significantly.
Reverse mortgages also offer the ability to take money in a lump sum, which can be very useful for home repairs or consolidating other debt. A traditional refinance will only lower the amount that you pay monthly or change the loan term. A cash-out refinance would be necessary to receive actual cash to use as you please.
Cons of Reverse Mortgages
The biggest drawback of a reverse mortgage is depleting your equity with every monthly payment. If you have no plans for your home for the long run, this may not be a significant concern. If you want to leave your home to your children as an inheritance, then you’ll be gutting the value of the gift.
When comparing the costs of each tool, reverse mortgages also tend to be more expensive. Since they are non-recourse loans, the FHA requires up-front mortgage insurance premiums of 2% of the total borrowed and an additional 0.5% mortgage insurance premium each year. This 0.5% is based on the amount borrowed. If there is adequate equity for a home being refinanced, then mortgage insurance isn’t necessary.
Pros of Refinancing
Refinancing is typically a cheaper option for most people in the long term. It does not require a counseling session (which averages $125 per session) like a reverse mortgage does. Interest rates tend to be lower for refinancing as well. You’ll also save on mortgage insurance premiums.
You will still make payments to the bank, but you also will still build equity in your home instead of depleting it. Continuing to build equity means that you’ll reap more profit when you’re ready to sell the house or pass it on to your heirs.
A refinance also puts your spouse in less peril of being rendered homeless if you’re married. If you open a reverse mortgage alone, then the non-borrowing spouse may have to vacate the residence if you move to long-term care. Laws are gradually changing to protect against this, but it’s something to think about.
Cons of Refinancing
If eliminating monthly payments is your goal, then refinancing is not for you. You will likely save money in the long run, but you’ll still make monthly payments to the bank, although they may be smaller.
If you need cash for home improvements or to pay property taxes—two common reasons for a reverse mortgage—then a cash-out refinance would be a better choice. You can take advantage of a lower interest rate or a shorter loan term and take out cash in a lump sum for project costs.
Can I refinance to pay for home improvements?
Depending on the interest rate and the term length of your refinance, you may be able to pay for home improvements by refinancing your home. If you need a large sum at once, you might consider a cash-out refinance instead. This allows you to pull out more equity in the form of a lump sum, in addition to the remaining balance on your original loan.
Will I still build equity if I refinance my house?
Yes. Refinancing your loan means that it changes the terms of your loan. You don’t lose any equity, and you continue to build equity, albeit at a lower interest rate or shorter or longer time.
Do I need a specific amount of equity to refinance my house?
As opposed to reverse mortgages, which require a considerable amount of equity to draw against, refinancing your home typically requires much less. Many lenders require at least 20% equity to refinance a loan. If you have less than 20%, your lender may still allow you to refinance but may require private mortgage insurance, which is added to your monthly payment.
The Bottom Line
If your financial situation allows you to refinance your home instead of taking out a reverse mortgage, a refinance is almost always a cheaper choice. It also allows you to continue building equity so that when you do decide to sell, you get much more of the profits from the house.
However, if you need to eliminate monthly payments for your budget to work, then a reverse mortgage is a valid option. Consider your goals carefully before making a decision.