In basic terms, home equity is the percentage of your home’s overall value that you personally own. So if you owe money on a mortgage, that part isn’t included in your equity. There are multiple ways to tap into home equity, including a reverse mortgage, home equity loan or home equity line of credit (HELOC). Deciding between these three viable options really depends on the specifics of your personal situation. A financial advisor who serves your area can help you understand how home buying fits into your financial plan.
What Is a Reverse Mortgage?
A reverse mortgage allows eligible homeowners to receive cash against the value of their home equity. The most common type of reverse mortgage is a Home Equity Conversion Mortgage or HECM. This type of reverse mortgage is designed for homeowners who:
Are 62 years of age or older
Own and live in an eligible property type (such as a single-family home)
Can afford ongoing costs of homeownership, including homeowners insurance, maintenance and taxes
Have no mortgage and own their home outright or have at least 50% equity
Are not delinquent on federal taxes or federal student loans
Homeowners must also complete HUD-approved reverse mortgage counseling. If you qualify for a reverse mortgage, you may be given the option to receive monthly payments, a lump-sum payment or have access to a revolving line of credit.
Even though it has “mortgage” in the name, a reverse mortgage is not a mortgage loan that you have to make payments toward. Instead, the reverse mortgage company makes payments to you during your lifetime, based on what your home is worth and how much equity you have in it. Then when you pass away, the money must be paid back, typically through the sale of your home as part of your estate settlement.
What Is a Home Equity Loan?
A home equity loan is essentially a second mortgage you take out using the equity in your home as collateral. When you take out a home equity loan, you can receive a lump-sum payment of cash which then has to be repaid over time with interest. The amount you can borrow is based on your home equity and the lender’s loan-to-value (LTV) ratio requirements. It’s common for lenders to limit home equity loans to up to 85% of the home’s LTV ratio.
Repayment works similar to a first mortgage in that you’re required to make monthly payments to a home equity loan. Depending on the terms of the loan, repayment may last anywhere from five to 20 years or possibly longer. Interest rates are fixed rather than adjustable, so you don’t have to worry about the rate or the payment increasing.
The payments you make toward a home equity loan are in addition to your regular mortgage payment. So before taking out a home equity loan, it’s important to consider how much your payment might be and whether that’s affordable for your budget.
How a Home Equity Line of Credit (HELOC) Works
A home equity line of credit or HELOC is a flexible credit line that allows you to withdraw cash as needed. HELOCs are structured with a draw period, in which you can withdraw cash, and a repayment period in which you repay what you borrowed with interest. Similar to a credit card or any other line of credit, you only have to repay the part of your available credit that you used.
There may be no payment due at all during the draw period, other than interest payments. The repayment period typically lasts five to 10 years, depending on the terms of your HELOC. Rather than having a fixed rate, a home equity line of credit may have a variable interest rate. This means your rate – and your monthly payment – can increase or decrease over time to keep pace with fluctuations in the benchmark rate.
Reverse Mortgage vs. Home Equity Loan
Reverse mortgages and home equity loans can be used to serve different purposes. Because of the age requirement associated with Home Equity Conversion Mortgages, reverse mortgages are typically designed to provide an additional stream of income for homeowners in retirement. Seniors may rely on monthly payments from a reverse mortgage to help pay for day-to-day living expenses or cover health care costs not covered by Medicare or other insurance.
There are some catches, however. First, a reverse mortgage is not free money. It does have to be repaid eventually which usually involves the sale of the home after the homeowner has passed away. If you’d like to leave your home to your children eventually, then you’d need to make some other financial arrangement to ensure they have the money to settle up with your reverse mortgage lender.
There’s also a stipulation about residency. A reverse mortgage typically needs to be repaid if you move out of the home, including if you move into a nursing facility for 12 months or longer. There may be an exception if you’re married and your spouse is still living in the home. But that’s something to be aware of when considering a reverse mortgage.
A home equity loan doesn’t have an age requirement. Qualification is based instead on how much equity you have in the home, your credit scores and your overall financial situation. In terms of how you can use a home equity loan, they’re often used for things like:
Home improvements or repairs
Paying off medical bills
Higher education expenses
You do have to make payments toward the home equity loan. But you don’t have to worry about your heirs being forced to sell the home to repay the debt when you pass away, assuming that you haven’t defaulted on the loan. It’s important to note that if you do default on a home equity loan during your lifetime this could result in a foreclosure and loss of the home.
Home Equity Loan vs. HELOC
A home equity loan and a HELOC can be used for the same purposes but they work very differently. With a home equity loan, you’re getting a lump sum of money. You’re responsible for repaying the entire amount, along with any interest and fees charged by the lender. Repayment typically begins right away, though a fixed interest rate means your monthly payments are predictable which can make budgeting easier.
With a home equity line of credit, you only have to repay the amount you borrow. So if you have a $100,000 HELOC limit but only use $50,000 of it you’d only have to repay that $50,000 plus interest and fees. You can use your home equity line of credit while only making interest payments during the draw period with full repayment kicking in later. But budgeting for those payments could be more difficult if your variable interest rate moves up or down.
Reverse Mortgage vs. Home Equity Loan vs. HELOC: Which Is Best?
The best way to tap into your home equity is ultimately the one that:
Provides you with the amount of cash you’re hoping to borrow
Offers a realistic and affordable repayment structure
You’re able to qualify for
If you’re 62 or older and need to supplement Social Security benefits, 401(k) withdrawals or other income in retirement, then a reverse mortgage could help. It’s important, however, to understand how a reverse mortgage could affect estate planning if your heirs are required to sell the home when you pass away.
A home equity loan or HELOC can provide you with cash that you can use for a variety of expenses but they may have very different costs. If you’re looking for predictability when it comes to budgeting debt repayment, then a home equity loan could be the better fit. On the other hand, if you’re unsure exactly how much money you may need and you’re comfortable with the possibility of payments changing over time then you may lean toward a home equity line of credit instead.
Comparing a reverse mortgage vs. home equity loan vs. HELOC is easier when you have a feel for how each one works and what they’re designed to do. It’s also helpful to remember that there’s one more way to make use of your home equity: A cash-out refinance. With a cash-out refi, you’re refinancing your existing home loan into a new one and getting the difference in cash. Talking to a mortgage expert or a financial advisor can help you compare the various options for making the most of home equity.
Mortgage Planning Tips
Consider talking to a financial advisor about how the influxes of cash the above options can offer could affect your long-term financial plan. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Be sure to check our free mortgage calculator as you make decisions. It can help regardless of whether you’re applying for a conventional mortgage, a reverse mortgage, a HELOC or home equity loan.
If you plan on adjusting your mortgage, it’s imperative to know the state of the current rate environment. Check out SmartAsset’s mortgage rates table to get started.
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