I’ve chatted with many seniors over the years who believed that a HELOC is a better option than a reverse mortgage for cash in retirement. Many seniors take HELOCs instead of reverse mortgages at the recommendation of well-meaning CPAs, attorneys, financial advisers, and relatives. Unfortunately, this is often a mistake.
HELOCs are a great loan product, but they’re not suited for long-term cash needs in retirement. They come with a number of pitfalls, but there’s one in particular that can be devastating for seniors who rely on them for cash in retirement.
What is a HELOC and how does it work?
The HELOC, which stands for home equity line of credit, is offered by many banks as an easy way to access home equity on a revolving basis. In other words, like a credit card, you can borrow, repay, and reborrow again.
The HELOs is a great mortgage product, but it’s simply not designed to be a long-term solution. In fact, over the long term it can be a financial ticking time bomb that can bite unsuspecting seniors badly. HELOCs are better suited for short-term cash needs where the homeowner borrows and repays a relatively short-term basis.
The following are some of the features of a HELOC:
- Interest-only payments. Most HELOCs have low minimum payments that only cover the interest. Unless you pay extra toward the principal, the debt isn’t paid down over time.
- Adjustable rates. Though some HELOCs have fixed rates, most come with adjustable interest rates. If rates increase, the payment will as well.
- Full recourse. If home values fall and you owe more than the home is worth on your HELOC, 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. 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.
- HELOCs can sometimes damage your credit scores. Though HELOCs are mortgages, they’re not always reported as such on your credit report. Often they’re reported as “revolving” accounts, which is how credit cards are reported. If you carry a large balance on your HELOC (more than 30% of the credit limit), it may appear like you have a highly leveraged or maxed out credit card on your credit profile, This can damage your credit scores even if you’re making your payments on time.
The biggest HELOC pitfall
All of the above are potential pitfalls for seniors who rely on HELOCs for their retirement cash needs. However, the biggest pitfall is this: a HELOC can be chopped, revoked, or taken away at any time. You cannot rely on a HELOC to always be there when you need it.
Unfortunately, Wells Fargo HELOC customers found this out last summer when Wells Fargo decided to close all personal lines of credit. Wells Fargo is a huge bank, so it’s a good bet there are numerous seniors among the HELOC customers who found themselves without the financial backup plan they were counting on.
A much better option for seniors
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 a HECM, or home equity conversion mortgage. The HECM is a better option because it’s designed to be a reliable cash source in retirement.
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 (or non-borrowing spouse) 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, term or tenure income, line of credit, or some combination of all of these. The line of credit is an ideal substitute for a HELOC for several 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. There is no practical limit to how much your line of credit can grow.
- 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.
If you’re a senior and you want to utilize home equity to increase your retirement financial security, a HECM is probably a far better option than a HELOC. Again, a HELOC is better suited to short-term cash needs. Seniors who attempt to use a HELOC as a long-term financial solution often get burned by the recast. Even worse, a HELOC can be revoked or chopped at any time. It simply can’t be relied on to always be there.
A HECM line of credit is designed to reliably give you access to your home equity throughout retirement. As long as program obligations are met, you can rely on it to be there when you need it.