Home equity loans and reverse mortgages both offer borrowers a way of accessing equity they’ve built up in their homes. Other than the fact that both loans are used to tap equity and use the borrower’s home as collateral, they function quite differently. Here’s an explanation of how each works and some things to consider when deciding between a home equity loan vs. a reverse mortgage
How a Home Equity Loan Works
Borrowers who take a home equity loan get a single cash payout of a specific amount they pay off in installments over a specified period, usually between 5 and 20 years, at a fixed interest rate. The amount available to the borrower is determined by the amount of equity and the lender’s discretion, but it is generally limited to 85% of the home’s loan-to-value ratio (LTV).
Individual lenders may set their own eligibility guidelines, but, generally, anyone who meets the lender’s credit, equity, and employment requirements can take a home equity loan.
What is the Loan-to-Value Ratio?
The loan-to-value-ratio is a formula used to measure the ratio between the requested loan amount and the home’s current market value. To calculate the LTV divide the current loan balance by the current appraised value of your home and multiply that number by 100.
EXAMPLE: If you get a $70,000 mortgage to buy a $100,000 home, then your loan-to-value ratio is 70%.
How a Reverse Mortgage Is Different
Unlike a home equity loan, a reverse mortgage does not have a fixed term, and the borrower does not pay back the loan in installments. Rather than a single lump sum, borrowers can choose to take their payments as a lump sum, monthly installments, a line of credit, or a combination of the three. Interest accrues on the loan balance but is not due until the borrower passes away, sells, or moves.
There are other notable differences between a reverse mortgage and a home equity loan:
- Minimum Age. Available only to people 62 or older for government-backed home equity conversion mortgages (HECMs). Age requirements may vary for proprietary reverse mortgages.
- Nonrecourse. Borrowers and their heirs will never owe more than the home’s value when it is sold to pay back the mortgage.
- Equity Restrictions. Borrowers taking a home equity conversion mortgage are subject to government-mandated restrictions on the amount of available equity they can borrow in the first year of the loan and the total amount they can withdraw.
Inheriting a Home Equity Loan or Reverse Mortgage
Many people deciding between a reverse mortgage and a home equity loan, especially in retirement, want to understand the implications of each on their inheritance.
When a reverse mortgage comes due, the balance, including accrued interest, must be paid in full. Often this is done by selling the home. Heirs who inherit the mortgaged home can choose how they would like to pay the balance, either by selling or some other means. Because reverse mortgages are nonrecourse, heirs will never take on personal debt to satisfy the loan, even if the house is underwater when the mortgage comes due.
Conversely, a home equity loan is not considered nonrecourse. Should the borrower pass away before paying off the loan, their estate will be responsible for taking on the debt or satisfying the loan.
Home Equity Loans and Reverse Mortgages Compared
Here’s a side-by-side comparison of the main differences between the two types of loans.
|Home Equity Loan||Reverse Mortgage|
|Age Requirements||None||62 or older for HECM.|
|Credit Score||Between 670-739 Lenders use credit score as one factor. Borrowers could qualify with a lower score in some cases.||No minimum, eligibility dependent on the results of the financial assessment|
|Monthly Payments||Based on loan amount/interest term||None required*|
|Interest Rate||Fixed||Usually variable|
|Disbursement||Single lump sum||Monthly payment, lump sum, or line of credit|
Home Equity LoanNone
Reverse Mortgage62 or older for HECM.
Home Equity LoanBetween 670-739 Lenders use credit score as one factor. Borrowers could qualify with a lower score in some cases.
Reverse MortgageNo minimum, eligibility dependent on the results of the financial assessment
Home Equity LoanBased on loan amount/interest term
Reverse MortgageNone required*
Home Equity LoanFixed
Reverse MortgageUsually variable
Home Equity LoanSingle lump sum
Reverse MortgageMonthly payment, lump sum, or line of credit
*Though reverse mortgages do not require monthly payments, borrowers must continue paying other charges associated with homeownership, including property taxes, fees, and hazard insurance.
How to Decide Which Loan Is Right for You
Assuming you are eligible for both types of loan, the choice of which is more beneficial to your specific situation will depend on multiple factors, including your:
- Current cash-flow. What is your capacity for adding additional payments to your monthly budget? Would removing loan payments be helpful to you?
- Estate plan. What are your hopes for passing your home on to heirs? Is it important to you that they can inherit your home?
- Intentions for the loan proceeds. Do you have a one-time need that will be satisfied with a single payout? Or would payment options help you address longer-term retirement planning needs?
- Larger retirement strategy. What type of retirement savings do you have, and how will those savings hold up over time?
When making any substantial financial decision, it’s always best to consult a qualified financial advisor who can help you consider when deciding between a home equity loan vs. a reverse mortgage.
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.