Older homeowners have several options to leverage home equity while still living in their primary residence. Often people weigh a cash-out refi versus a reverse mortgage when deciding how best to access funds. Each has advantages and disadvantages. Before choosing one over the other, it’s crucial to understand how each works.
What Is a Cash-Out Refi?
The process for a cash-out refi is similar to refinancing an existing traditional mortgage. In a traditional refi, the borrower pays off an existing mortgage loan and secures a new loan. The terms are different from the original loan, likely with a lower interest rate, shorter term, or both. In a cash-out refi, there are new terms, and the borrower may withdraw a portion of the home’s equity as a lump-sum cash payment.
What Is a Reverse Mortgage?
A reverse mortgage is a loan that allows borrowers 62 years and older to convert part of their home’s equity into cash while still living in their house. These loans are structured so that no monthly mortgage payments are required. As a condition of the loan, borrowers must live in the home as their primary residence, pay property taxes and insurance, and maintain the house.
What Are the Differences Between a Cash-Out Refi and a Reverse Mortgage?
Both a cash-out refi and a reverse mortgage allow the borrower to take advantage of accumulated equity, but there are key differences between the two loans.
To be approved for a cash-out refi, the borrower must have an appropriate debt-to-income ratio and meet income and credit score requirements. The loan officer may require proof of two years of income, and a credit check will likely be part of the process. There is no age restriction on a cash-out refi.
With a reverse mortgage, the borrower and property must meet all eligibility conditions, and the borrower must generally be 62 years or older. To qualify for a reverse mortgage, borrowers must also attend a counseling session before closing to ensure they fully understand the rights and responsibilities of the loan.
Loan Payout and Payments
The cash-out refi allows the borrower to receive a cash payment wrapped into the total amount of their new mortgage. The borrower gets the cash-out funds to use at their discretion then makes monthly mortgage payments under the terms of their new mortgage. These monthly payments cover both principal and interest, and the borrower’s equity in the home typically increases as monthly payments are made.
For a reverse mortgage, the borrower may receive loan proceeds as monthly payments, as a lump sum, as a line of credit, or a combination of the three. A critical difference between a cash-out refi and a reverse mortgage is that a reverse mortgage does not require a monthly mortgage payment. The loan balance grows over time as accrued interest is added to the loan, which may decrease the borrower’s equity in the home. As long as the borrower meets the terms of the loan, it does not need to be paid back until the borrower sells the house, passes away, or no longer occupies the home as their primary residence. Reverse mortgage borrowers are still responsible for homeowners’ insurance, property taxes, maintenance, and other fees associated with the home (e.g., HOA fees).
When Does a Cash-Out Refinance Make Sense?
If a lower interest rate is available and the borrower has substantial equity in the home, a cash out-refi is a favorable option. Like any loan, homeowners must meet qualifications to secure a cash-out refi.
Here are several additional factors that might make a cash-out refi a good option:
- The borrower is employed and receives steady income or substantial cash flow from retirement accounts.
- The borrower wants to secure a lower interest rate and, in exchange, is able to take on higher monthly mortgage payments.
- The borrower needs funds for a home improvement project, debt consolidation, or college education.
A cash-out refi is often a great option for the homeowner who can afford monthly mortgage payments and wants to use the cash out to increase the property’s value, for example, building a swimming pool. It also could make sense to use it for investments like funding a child’s college tuition (especially if the interest rate is lower than a student loan).
When Does a Reverse Mortgage Make Sense?
Older homeowners who want to stay in their homes and take advantage of their accumulated equity may find a reverse mortgage a viable option. A reverse mortgage can help older borrowers pay off healthcare expenses, supplement income, or fund home improvements without putting additional stress on their monthly cash flow.
A reverse mortgage may be preferable to a cash-out refi under these circumstances:
- The borrower needs to supplement income in retirement or struggles to qualify for other loans.
- The borrower is on a limited budget and wants to forego making monthly mortgage payments.
- The borrower wants to make lifestyle changes like traveling but has the necessary funds wrapped up in their home equity.
A reverse mortgage caters to older borrowers who want to tap their home equity to improve their cash flow or pay for a significant expense their current budget doesn’t allow for.
What Is the Bottom Line?
Both types of loans have pros and cons, and everyone’s situation is different. The best option for you will depend on your financial situation and goals, so talk to a trusted financial advisor or lender before committing to a decision.
This article is intended for general informational and educational purposes only, and should not be construed as financial or tax advice. For more information about whether a reverse mortgage may be right for you, you should consult an independent financial advisor. For tax advice, please consult a tax professional.