April 7, 2017 by HECM Pro
So, you’re retired and need a financial fallback plan. You’re considering the merits of a HECM vs HELOC, but you’re not sure which one is better. Which is the better option? What are the pros and cons? What are the potential pitfalls?
There’s no question it’s good to have more than one option when it comes to meeting unexpected expenses in retirement. It’s for this reason that many retired homeowners take out HELOCs. It gives them a way to tap into their home’s equity to cover emergency expenses such as medical bills, home repairs, or other expenses.
This can sound like a great financial strategy at first glance, but unfortunately, it can be fraught with pitfalls. In my opinion, the HECM reverse mortgage line of credit is a far better solution. But before I explain why, let’s cover some basics.
What is a HECM Reverse Mortgage?
A HECM reverse mortgage is a type of home loan that allows homeowners 62 years of age or older to convert a large portion of the value of their home into tax-free cash without having to give up ownership of the home or take on a mortgage payment. As long as at least one borrower is living in the home and paying the required property charges (property taxes, homeowners insurance, etc.), no mortgage payment is ever required and the loan doesn’t have to be paid back.
The proceeds from a HECM reverse mortgage can be received in several ways, including lump sum, a monthly paycheck, line of credit, or some combination of all of these.
Because we’re comparing HECM vs HELOC, I’m going to focus on the line of credit option.
HECM vs HELOC: Which Makes More Sense For Retirees?
First of all, the HECM line of credit and the HELOC are both fully revolving and offer the ability to borrow and repay the principal at your leisure. However, the similarities largely stop there. It’s the key differences between the HECM line of credit and the HELOC that make the HELOC, in my opinion, one of the riskiest loans for retirees.
A HELOC is a great product, but like a tool in a toolbox, it has to be used for the correct purpose. They’re simply not designed to be long-term solutions. In fact, over the long term they’re often a financial ticking time bomb that can come back to bite you badly. HELOCs are far better suited for short-term cash needs where you borrow and repay on a relatively short-term basis.
The following are some of the potential pitfalls of HELOCs that I hope will settle the HECM vs HELOC debate for good:
- Interest-only payments. Most HELOCs have low minimum payments that only cover the interest. Unless you intentionally make extra payments, the debt isn’t paid down over time.
- The more you borrow, the bigger the payment. This can become a real financial headache if you use a HELOC to cover big expenses such as medical bills, car repairs, or home maintenance. The more you borrow, the bigger the payment gets and the bigger the financial burden it becomes.
- Adjustable rates. Though some HELOCs have fixed rates, most come with adjustable interest rates. If rates rise, the payment will as well, which further exacerbates problem #2 above.
- They can be revoked, chopped, or frozen with little notice. This is less than ideal if you plan to use the HELOC as a long-term financial safety net. If home values fall or credit conditions deteriorate, banks will take steps to reduce their risk exposure. It’s entirely possible your HELOC will be revoked, chopped, or frozen when you need it most.
- They are typically full recourse loans. If home values fall and you end up owing more than the home is worth, the bank will come after you for the shortage if you try to sell your home. You will either have to come up with a lot of cash or negotiate a short sale to get your home sold. And if you can’t keep up with the payments, you may face foreclosure and a deficiency judgment for the unpaid loan balance.
- The recast. This is probably one of the most devastating problems with HELOCs. Unfortunately, most borrowers only find out about this potential financial iceberg when they’re about to crash full-on into it. Most HELOCs allow you to withdraw funds for up to the first ten years of the loan. At the ten-year mark, the bank recasts the loan into a full principal and interest payment that pays back the entire balance over a relatively short time period. If your balance is large, this can mean your payment increases by hundreds of dollars or more. I can think of one particular client a few years ago who had this happen to her. She’d had her HELOC for 10 years and the payment recast from a manageable $150 to over $700. Since she was on a fixed income, she struggled to make the payment and was at risk of losing her home.Ten years might seem like a long time in the future, but those years pass quick. This is not a situation you want to be in if you’re in your late 70s or 80s and perhaps not in the best of health.
Again, the HELOC is a risky way for retirees to borrow against their home’s equity for emergency cash needs. The far better solution is the HECM line of credit for several important reasons:
- No payment is ever required (as long as program obligations are met).
- If you borrow more, there’s still no payment required.
- Rates can be adjustable, but if they increase, the payment is still zero.
- The line of credit cannot be chopped, revoked, or frozen as long as you meet your program obligations. Even better, your available credit will grow and compound larger, which gives you access to more money automatically over time.
- HECMs are non-recourse. The most that is ever paid back is the value of the home, even if it’s not worth enough to settle the entire balance.
- No recast. Again, there is never a payment required as long as you meet your program obligations.
- HECMs are often much easier to qualify for than HELOCs. You don’t need to have stellar credit to qualify for a HECM reverse mortgage.
Settling the HECM vs HELOC Debate
A HELOC is a good loan product, but like any tool in a toolbox, it needs to be used for the right purpose. It is not a good long-term solution for emergency cash needs. There’s simply too many pitfalls and risks.
Again, the last thing you need in your 70s or 80s (when perhaps your health isn’t too great) is to be worried about losing your home because of the HELOC you took out ten years before.
In my opinion, the HECM line of credit comes out far ahead in the HECM vs HELOC debate.