Many older homeowners who are short on cash can use their homes as a source of income. This often involves choosing between a reverse mortgage and a home equity loan or home equity line of credit (HELOC).
Both of these strategies can be turn home equity into cash that can help cover medical bills, living expenses, loans to family members or almost any other need.
Home equity loans: an overview
Home equity loans work like a regular mortgages, so they are often called “second mortgages.” Once you’ve paid down at least 20 percent of your original mortgage you are able to borrow additional money against the equity you’ve built. Then, you pay back that money through regular installments that cover interest and principal.
There are two main types of home-equity borrowing:
- A fixed-rate home equity loan provides a lump-sum payment that is paid back through regular monthly payments based on a fixed interest rate.
- Home equity lines of credit provide a maximum amount you can potentially borrow that is linked to a person’s home equity. Tap that limit as needed, and you only pay interest on the amount you’ve borrowed.
Reverse mortgages: An overview
Unlike home equity loans, funds received from a reverse mortgage don’t need to be paid back in monthly payments. Instead, the total amount borrowed is due when the borrower dies, sells their home or moves permanently to another home. The income from a reverse mortgage can be accessed either through a lump-sum payment or regular monthly installments.
There are a few factors that can affect which option for tapping home equity is best for you:
- Your age: Reverse mortgages are only available to homeowners who are at least age 62, while home equity loans are available to homeowners of all ages.
- Your current home equity: You must either fully own your home or have a very small mortgage to qualify for a reverse mortgage, which can put a reverse mortgages out of some borrowers’ reach. To receive a home equity loan, on the other hand, you generally need to have at least 20 percent equity in your home.
- Your income and credit score: Both factors must be high enough to show a potential home equity lender that you will be able to make monthly payments. There are generally no credit score requirements for reverse mortgages, though a lender may require proof that the borrower can cover ongoing expenses associated with home ownership, such as property taxes and maintenance costs.
HELOC vs. reverse mortgage: Pros and cons
To choose which method is right for your circumstances consider the main advantages and disadvantages of each:
- Cost of borrowing. Although homeowners don’t need to pay interest on the money they receive from a reverse mortgage, the cost of the borrowing is usually higher overall than with a home equity loan. Reverse mortgages often involve higher closing costs and fees.
- Tax benefits. The interest you pay on any home equity loan up to $100,000 is usually tax deductible. Reverse mortgages offer no comparable tax advantages.
A reverse mortgage decreases your equity in your home in proportion to the amount of cash you receive. Home equity loans allow you to maintain equity in your home as long as you make regular payments on your balance. The risk, however, is that the equity you are using as collateral could be lost if you default on your loan.