You’re retired and you need a financial fallback plan. You’re evaluating the merits of a reverse mortgage vs home equity loan, but you’re not sure which is the better option. Which one should you go with? What are the potential pitfalls of one versus the other? Our goal here is to help you answer these questions.
It’s important to have a financial safety net in retirement. After all, you never know when unexpected expenses like home repairs or medical bills will come up. If you don’t have savings to cover the unexpected, then it’s important to have credit that you can borrow against at a reasonable interest rate and payment.
Many retired homeowners turn to home equity loans to cover unexpected expenses. The interest rates and payments are usually reasonable and they’re relatively easy to get if you have decent credit and plenty of home equity. In fact, many accountants, attorneys, and financial advisors recommend home equity loans to their retired clients.
In our opinion, home equity loans are not always a good idea for retirees. But before we explain why, let’s define some terms and cover some basics. There is a lot of confusion about how home equity loans and reverse mortgages work. This tends to muddy the waters in the reverse mortgage vs home equity loan debate.
Our goal is to provide clarity so you can more easily decide which product is best for you.
How Does a Home Equity Loan Work?
When people refer to a home equity loan, they’re usually referring to a home equity line of credit, or HELOC. HELOCs are commonly known as home equity loans, credit lines, or home equity lines of credit. We’ll use the term HELOC or home equity loan in this article.
A home equity loan, or HELOC, is typically structured as a revolving credit line that you can draw on and repay at will.
Most HELOCs come with variable rates and interest-only payments, which means you have to make extra payments if you want to actually pay the balance down.
The initial draw period is usually ten years. At the end of the draw period, your lender will close out your available credit and require you to start paying both principal and interest over the remaining loan term.
How Does a Reverse Mortgage Work?
The most common reverse mortgage in the United States today is the FHA-insured home equity conversion mortgage, or HECM (often pronounced heck-um by industry insiders). If somebody you know recently got a reverse mortgage, it likely was a HECM.
If you’re at least 62, the HECM enables you to convert a portion of your home’s value into tax-free cash. No mortgage payments are required as long as you live in the home and pay the required property charges.
You remain the owner of your home and can leave it to your heirs. If your heirs want the home, they can pay off or refinance the loan balance. If they don’t want the home, they can sell it and keep the remaining equity.
Your heirs can also let the lender sell the home if they don’t want it and don’t want to hassle with selling it.
The HECM is a non-recourse loan; the most you will ever have to pay back is the value of your home. FHA covers the shortage if your home isn’t worth enough to pay off the entire balance.
The credit line option is what I want to focus on here as we consider the pros and cons of reverse mortgage vs home equity loan.
Reverse mortgage vs home equity loan
So, which product is better in retirement? Well, that depends on your goals and financial situation. Let’s compare and contrast the features and merits of both the reverse mortgage credit line and the home equity loan, or HELOC.
First of all, the reverse mortgage credit line and the home equity loan are both revolving. In other words, they both offer the same convenient ability to borrow and repay whenever you like.
The similarities pretty much stop there, however. It’s the differences between the two products that make the home equity loan, in my opinion, a risky loan for many retirees (notice that I didn’t say a home equity loan is risky for all retirees).
A home equity loan is a great product, but like a tool in your toolbox, it should be used for the correct purpose. A home equity loan is not a good long-term financial solution – especially if you’re living on a fixed income. In fact, home equity loans are often financial ticking time bombs that come back to bite many unsuspecting retirees.
Home equity loans are best for short-term cash needs. In other words, you borrow and repay on a short-term basis. You don’t want to keep a large balance on a home equity loan for a long period of time.
Positives and Negatives of the Home Equity Loan
If you have good credit and a lot of home equity, you’ll usually find it pretty easy to get a HELOC. The closing costs are usually pretty cheap as well.
Having said that, there are some potential pitfalls you should be aware of:
- Interest-only payments. Most HELOCs have low minimum payments that cover just the interest. You won’t pay down the debt unless you make extra principal payments.
- The more you borrow, the bigger your payment. This can become a big financial headache if you use a HELOC to cover big expenses like medical bills, car repairs, or home maintenance. The more you borrow, the bigger your payment gets.
- Adjustable rates. Some HELOCs come with fixed rates, but most have adjustable interest rates. If rates rise, your payment will as well. This further exacerbates problem #2 above.
- Your lender can revoke, chop, or freeze your HELOC with little notice. You can’t rely on your HELOC to always be there when you need it – even if you have excellent credit. Your lender can revoke your available credit with little notice. This could be bad news if you’re relying on your HELOC to be a long-term financial safety net. If home values fall or credit conditions deteriorate, banks will reduce their risk exposure. Your lender could revoke, chop, or freeze your available credit when you need it most.
- They are typically full recourse loans. If home values fall, you could end up owing more on your mortgage than your home is worth. If you try to sell your home, the bank will come after you for the shortage. You will either have to come up with a lot of cash or negotiate a short sale to sell your home.
- 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 into it. As we’ve covered, 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 balance over the remaining loan term. This means your payment could increase by hundreds of dollars or more if you have a large loan balance. 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 her lender had just recast her payment from a manageable $150 to over $700 per month. She was retired and on a fixed income, so there was no way she could afford that payment. Unfortunately, she ended up facing foreclosure. 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, a HELOC is great for short-term cash needs, but it’s risky for retirees on a fixed-income who depend on it to be a financial safety net.
Positives and Negatives of the Reverse Mortgage Line of Credit
So what are the potential positives and negatives of the reverse mortgage line of credit? Well, let’s start with the positives:
- 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.
There are some potential downsides to a reverse mortgage:
- Closing costs. Reverse mortgage closing costs can be expensive, but they’re not always expensive. The biggest closing cost is usually the initial mortgage insurance premium, or IMIP. IMIP, along with MIP, is what makes the HECM non-recourse. FHA uses IMIP premiums to cover shortages when homes don’t sell for enough to pay off entire HECM balances. You’ll likely also incur third-party costs and origination fees. Though HECM closing costs can add up, they’re usually not paid out of pocket. Most lenders will roll them into the new loan amount. The exception is HECM for purchase; closing costs are paid out of pocket in addition to your down payment for purchase HECMs.
- Interest can pile up on large loan balances. If you have a large reverse mortgage balance, the interest can pile rapidly up in the later years of the loan. Again, there are no monthly mortgage payments, so unpaid interest accrues onto the loan balance over time. Interest compounds on top of interest, which means the loan balance can increase rapidly in the later years of the loan. Don’t forget, however, that the HECM is non-recourse. Even if you somehow owe more than your home is worth, FHA will cover the shortage.
- The application process is longer and more involved. It’s possible to close on a HELOC in just a few days, but it usually takes 45 to 60 days to close a reverse mortgage. The application process also involves more paperwork than a HELOC, but your lender will handle most of it.
Like any financial product, a reverse mortgage has pros and cons. However, in our opinion, the positives greatly outweigh the negatives – especially for retirees on a fixed income. A reverse mortgage line of credit is far less risky than a HELOC.
Settling the Reverse Mortgage vs Home Equity Loan Debate
A HELOC is a good loan product, but be careful with it if you’re retired. A HELOC can be risky for long-term cash needs if you’re living on a fixed income. Again, the more you borrow, the bigger your payment. If rates go up, the bigger your payment. Your lender will hit you with the recast at some point, which could make your payments unaffordable and put your home at risk.
You can’t rely on a HELOC to always be there. Your lender could take it away at any time with little notice.
The reverse mortgage line of credit is the clear winner in the reverse mortgage vs home equity loan debate, in my opinion. There are no monthly payments and you can’t lose your available credit as long as your meet your program obligations. Even better, the line of credit grows and compounds larger over time, which increases your financial security.