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

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Those with significant amounts of home equity have a few options to use it to get cash. Options include a reverse mortgage, a home equity loan or a home equity line of credit (HELOC).

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

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.

Home equity loan

A home equity loan is commonly 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 the equity of the home.

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.

Home equity line of credit (HELOC)

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 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.

After the draw period (usually five or 10 years), you enter the repayment period. During the repayment period, your payments will include both interest and principal, and 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.

Reverse mortgage

A reverse mortgage lets homeowners 62 or older convert their equity into cash. A lender gives the homeowner either a lump sum or monthly payments to supplement their Social Security, pension or other retirement income for daily and healthcare expenses.

Unlike with home equity loans or HELOCs, 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.

Key differences between a home equity loan, HELOC and reverse mortgage

All three of these financial instruments help homeowners access the equity in their homes, but do so in different ways. Each of them allow homeowners to use the funds for any purpose, ranging from paying off their high-interest credit cards to remodeling a bathroom. You’ll want to be careful about misusing the 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.

When a home equity loan is best

A home equity loan is 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 up front. If you borrow more than you need, you may find yourself paying interest on money you aren’t actively using.

Other advantages of a home equity loan compared with a reverse mortgage include much lower closing costs, application fees and appraisal fees. Borrowers of any age can apply for a home equity loan.

When a HELOC is best

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.

Like a home equity loan, a HELOC has much lower closing costs, application fees and appraisal fees than a reverse mortgage. There is also no age requirement to apply for a HELOC.

When a reverse mortgage is best

A retiree 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, says Greg McBride, CFA, chief financial analyst for Bankrate. Just remember that if you don’t make payments on your reverse mortgage, the interest continues to accumulate and the amount you owe the bank will increase.

Next steps

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 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.

Check out our home equity loan rates or our best HELOC rates to find the rates and lenders that might be best for you.

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