Home equity loan, HELOC or reverse mortgage: Which is right for you?


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Retirees have a few options to use their home equity to obtain cash by seeking either a reverse mortgage or a home equity line of credit.

Depending on the amount of equity in your home, either option can be suitable for your financial needs, though they each have quite different implications and costs.

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How a home equity loan differs from a HELOC

Homeowners can use the equity in their home to obtain two types of loans, either a home equity loan or a home equity loan or a home equity line of credit, or HELOC. These loans are helpful to homeowners, if the value of their homes have risen and or their mortgage has been paid off. Price appreciation gives them more equity in their homes to borrow against. Both loans allow homeowners to use the proceeds for any purpose, ranging from paying off their high-interest credit cards to remodeling a bathroom.

A home equity loan is commonly called a “second mortgage” and uses your home as collateral. Homeowners receive a lump sum that they pay back in equal monthly payments at a fixed interest rate, which means they don’t have to worry about making a larger monthly payment if interest rates rise. The term of the loan is usually five to 20 years. The amount that can be borrowed is typically limited to 80 percent of the equity of the home.

A HELOC gives a homeowner the ability to borrow money from the equity in their home and operates like a credit card, or revolving debt. A person can tap the credit line as they need money for medical or daily expenses or to make home repairs. During the first 10 years when you can draw down money from the loan, homeowners can make interest-only payments, which helps if they’re facing a tight budget. The interest rate is variable, which can lead to higher payments some months if interest rates spike or lower payments when rates go down.

What’s a reverse mortgage?

A reverse mortgage can be beneficial in some circumstances. Homeowners have to be 62 years or older to apply for one. A lender either gives the homeowner a lump sum or monthly payments to supplement their Social Security, pension or other retirement income for daily and healthcare expenses.

Unlike home equity loans, funds received from a reverse mortgage don’t need to be paid back in monthly payments. The money received from a reverse mortgage is paid back when the person chooses to move out, sells the home or dies.

HELOC vs. reverse mortgage: Pros and cons

The advantages of a HELOC compared with a reverse mortgage include much lower closing costs, application fees and appraisal fees.

“Compared to the often costly proposition of a credit card cash advance, there are no fees for withdrawing funds from a HELOC,” said Bruce McClary, spokesman for the National Foundation for Credit Counseling, a Washington, D.C.-based nonprofit organization. “Interest rates are also much lower than other lines of credit and there is a lifetime cap on how high the variable interest rate can go.”

One major disadvantage of a HELOC, though, is that the interest rate is generally variable. That means your monthly payment can fluctuate depending on whether interest rates are rising or falling.

“The rate may start low but could creep up over the life of the loan,” McClary said. “With a growing balance, the increasing interest rate can put extra pressure on a tight budget.”

One positive factor is that retirees can convert a variable-rate HELOC to a fixed-rate during the repayment phase of the loan.

Another risk associated with a HELOC is misusing the HELOC funds or racking up fresh credit card debt and falling deeper into debt. The most common uses of HELOCs, and ones recommended by personal finance pros, include paying for expensive home repairs and paying off high-interest credit card balances.

“A borrower can get in trouble if they run up the credit cards after using the HELOC to pay them off,” McClary said.

When a reverse mortgage might make sense

A retiree who has paid off the mortgage of their home or has a massive amount of equity in their home might consider seeking a reverse mortgage.

The advantage is that homeowners can tap their home equity in various forms – lump sum, regular monthly payments or line of credit – without the requirement of making monthly payments, said Greg McBride, CFA, chief financial analyst for Bankrate.

“This makes a budget-friendly option for retirees on a fixed income,” McBride said. “But the cost of obtaining one can be high due to the insurance that protects homeowners from ever owing more than the home’s value.”

One drawback of a reverse mortgage is that higher interest and fees will accelerate the rate of increase on the balance and limit the available amount of money left to withdraw over the life of the loan, McClary said.

“While this may not seem like much of a concern on the surface, it should be noted that reverse mortgage fees can often be higher than those associated with a conventional mortgage,” McClary said. “Reverse mortgage borrowers may be at risk of losing access to Medicaid or SSI (Supplemental Security Income) benefits in some situations. And there are circumstances where the loan balance may be due sooner than expected, such as the case when a spouse dies.”

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Maintaining equity

The amount of equity in your home is lowered when you take out a reverse mortgage, home equity loan or home equity line of credit.

“When borrowing from home equity, it increases the leverage and reduces your equity stake,” McBride said. “Whether you borrow a dollar on a HELOC or reverse mortgage, it reduces your equity by a dollar. But the balance grows on the reverse mortgage if you don’t make payments, further eroding equity. Borrowers do have the option of making payments on a reverse mortgage if they choose, as opposed to the required payments on a HELOC.”

A HELOC or reverse mortgage can use up some or most of the remaining equity in your home, which can be problematic if property values decline in your neighborhood, McClary said. One possible scenario is that the remaining balance of the loan could exceed the value of the property.

“While lender guidelines will establish the loan-to-value (LTV) percentage of the loan, that figure may fluctuate over the life of the loan due to changes in the balance and market influences on the property value,” McClary said. “It is wise not to push the limits when borrowing against the equity of your home.”

A homeowner who is considering a reverse mortgage should consult with a nonprofit agency that offers reverse mortgage counseling before entering into a loan agreement. The National Foundation for Credit Counseling (NFCC) offers access to HUD Certified Home Equity Conversion Mortgage (HECM) counselors who can help seniors make the best choice when deciding which option is best for their circumstances.