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Homeowners can use funds from each loan for any purpose; however, each type of loan works differently and one of these options may be more suitable for your financial needs. Before deciding between a reverse mortgage, a home equity loan or a HELOC, understand which is best for your circumstance?
What’s the difference between a home equity loan, HELOC and reverse mortgage?
All three of these financial instruments help homeowners access the equity in their homes, but they do so in different ways. Each allows homeowners to use the funds for any purpose, ranging from paying off their high-interest credit cards to remodeling a bathroom.
Home equity loan
A home equity loan is often called a “second mortgage” because it follows behind your first mortgage. A home equity loan uses your home as collateral. The terms are usually between five and 20 years, and the amount that can be borrowed is typically limited to up to 85 percent of home’s combined loan-to-value ratio.
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 larger monthly payments if interest rates rise. Because the interest rates and monthly payments are fixed, this can be helpful for people who are looking to budget a specific amount to repay each month.
Takeaway: A home equity loan or second mortgage uses your home as collateral and gives you a fixed amount of money upfront, with set monthly payments for the length of the loan.
Who it’s best for: Borrowers with a lot of equity who have a specific purpose in mind for the money. Because you receive a lump sum when you take out a home equity loan, it’s best to know exactly how much you’ll need upfront.
A home equity line of credit (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 part of the HELOC (called the draw period) you can draw down money from the loan and make interest-only payments, which helps if you’re facing a tight budget. The draw period usually lasts five or 10 years.
Afterward, you enter the repayment period, which generally lasts 10 to 20 years. During the repayment period, your payments will include both interest and principal, and they may be significantly higher than the payments during the draw period. The interest rate on a HELOC is generally variable, which can lead to higher payments during some months if interest rates spike, or lower monthly payments when rates go down.
Takeaway: A HELOC works in a similar way to a credit card, where you can spend as much or as little as you need, up to a specified credit line amount.
Who it’s best for: If you’re not sure exactly how much money you need to borrow, a HELOC can be a good option. This is because you’ll pay interest only on the amount you’ve actually borrowed.
With a reverse mortgage, the lender either gives the homeowner a lump sum or monthly payments to supplement their Social Security, pension or other retirement income for daily and health care expenses. Homeowners have to be 62 or older to apply for one.
A reverse mortgage can be beneficial in some circumstances. Unlike with 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.
Takeaway: You must be 62 or older in order to qualify for a reverse mortgage. Monthly payments are not required, but if you don’t make monthly payments, interest will continue to accrue until the homeowner moves out, sells the home or dies.
Who it’s best for: An older homeowner who has paid off their mortgage or has a massive amount of home equity might consider seeking a reverse mortgage. The advantage of a reverse mortgage 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.
What to watch out for
There are a few things that you’ll want to watch out for when accessing your home equity in one of these three ways. You’ll want to be careful about misusing the funds or racking up fresh credit card debt and falling deeper into debt.
By taking out a loan against your home, you could be undoing years of equity building. Additionally, taking on debt could increase the risk that you won’t be able to pay it back. Failure to make timely payments could result in penalties, fees or foreclosure and your credit score could take a hit. This could affect your ability to borrow in the future or to qualify for low interest rates.
If you have an adjustable rate, your payments could also increase as interest rates rise. Interest rates are unpredictable, and you could end up paying much more than you originally intended.
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. If you’re using your home equity for any other purpose, you may find yourself on shaky financial ground.
If you’re considering tapping into some of the equity in your home, you’ll first want to decide which of these products is right for you. No matter which one you choose, you’ll want to make sure to gather your important documents like your home’s information, tax returns and proof of income. Having those documents handy will help expedite the loan process.
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 NFCC-certified Home Equity Conversion Mortgage (HECM) counselors who can help seniors make the best choice for their circumstances.