Compare Reverse Mortgage vs. Home Equity Loans & HELOCs for Retirement Income
When you’ve already retired and you need income, one potential source of income many retirees consider is their home equity.
Sometimes Social Security payments and income from other assets aren’t enough.
Banks have many products that allow you to access your home equity. These products include reverse mortgages, home equity loans and home equity lines of credit (HELOCs).
Unfortunately, tapping your home’s equity to get income in retirement usually isn’t a great idea.
Sometimes it is your only option. In these cases, you need to know your options.
If you’ve already decided you’re going to tap your home’s equity to get retirement income to pay for living expenses, here are the differences between a reverse mortgage vs. home equity loan vs. HELOC.
What Are Reverse Mortgages and How Do They Work?
Reverse mortgages, sometimes called a home equity conversion mortgage, allow certain people to withdraw equity from their homes.
The key is:
These mortgages allow you to do this without you having to repay the amount owed in monthly payments.
There are many requirements to get a reverse mortgage.
Significant equity required
You have to have significant equity in your home or own it outright. If you still owe money on the home, you normally have to pay off the existing mortgage with money from the reverse mortgage.
Must be primary residence
Next, you have to live in and continue to live in the home as your primary residence.
The youngest borrower must also be age 62 or older.
While you live in the home, you must continue paying property taxes, insurance, HOA dues and maintain the house. This makes sure the reverse mortgage lender can get repaid down the road.
Depending on the reverse mortgage option you choose, you can receive money in many ways. Common options include:
- A lump sum
- Monthly payments
- A reverse mortgage line of credit
- A combination of a line of credit and monthly payments
With a reverse mortgage, you won’t have to make a mortgage payment to pay off the debt, either.
The balance is paid off by selling the home when you vacate it as your primary residence or you die.
There are other details that are important to learn before you take out a reverse mortgage. Some reverse mortgages may offer fixed interest rates while others have variable interest rates.
Reverse mortgages usually have many fees, as well.
Closing costs could eat up a significant chunk of your equity.
These fees could include origination fees, servicing fees, mortgage insurance premiums and other costs.
When borrowing money with a reverse mortgage, you won’t get access to your entire home equity. The money you borrow will accrue interest and add to the amount you owe.
The lender wants to make sure that they’ll get repaid when the reverse mortgage ends.
For that reason, they only allow you to borrow a portion of your equity. As time goes on, interest on the loan will eat up part of your equity, as well.
Reverse mortgages are complex.
They’re typically a fairly expensive way to borrow money, too. Make sure you understand exactly how they work before you take one out.
What Happens With a Reverse Mortgage When You Die?
A reverse mortgage generally works in one of several ways when you die.
First, if you have a surviving spouse that is also listed on the reverse mortgage, nothing normally happens.
The surviving spouse can stay in the home until they pass away or vacate it as their primary residence.
Home may be sold
If everyone on the reverse mortgage dies, the home is usually sold. If the proceeds are in excess of the balance owed on the reverse mortgage, any excess often goes to your heirs.
If it doesn’t, the sale of the home generally repays the balance owed in full.
Your heirs may have another option, too.
They could pay off the loan balance owed with other funds to keep the home in the family.
What Are Home Equity Lines of Credit (HELOC) and How Do They Work?
A home equity line of credit (HELOC) allows you to borrow money against the equity in your home.
Depending on the HELOC you choose, you may be able to borrow money until you only have 15% or 20% equity left in your home.
HELOCs typically come with variable interest rates.
The interest rate may increase or decrease over time.
It is usually based on a benchmark interest rate, such as the prime rate, plus a premium.
A HELOC generally starts with a draw period that may last about five to 10 years.
During the draw period, you can borrow money against your line of credit.
While in the draw period, you may be able to pay interest-only payments on your loan. That means you may not pay down any principal owed. This makes the monthly payments smaller.
Once the draw period ends, you enter the repayment period. This period is often 10 to 20 years.
You have to start making principal payments in this period, so your payment will increase. You can no longer withdraw money during this time.
What Are Home Equity Loans and How Do They Work?
Home equity loans are easier to understand than HELOCs. With this type of loan, you borrow a lump sum up front.
Interest rates on these loans are usually fixed rate. This allows you to have a predictable payment.
Home equity loans typically require you to leave 10% to 20% equity in the home after the loan is taken out.
You immediately start making payments on the loan. The loan repayment period normally lasts five to 15 years but can vary by lender.
A home equity loan could be useful if you need to make a big purchase, like a new car, and don’t have another way to pay for it.
Another option is using the set amount of money you take out as a lump sum to generate income in retirement.
What Happens With a Home Equity Line of Credit (HELOC) or Home Equity Loan When You Die?
What happens to a HELOC or home equity loan when you die depends on your situation.
It depends on your specific loan and your state laws.
That said, here are some common results.
If you have a co-borrower, they may be able to continue using the HELOC or home equity loan as it stands. They’ll have to continue making payments. If they can’t, they’ll have to sell the home or find another way to pay off the loan.
If you don’t have a co-borrower, a family member may be able to assume the loan and continue to make payments.
This depends on your mortgage and state laws. It may not be possible in all situations. Ask your bank to see if they’d be willing to work with your situation.
If no one can take over the loan, your heirs can sell the home and use the proceeds to pay off the loan.
Alternatively, your heirs could take other money from the estate, if there is any, to pay off the loan.
When Does It Make Sense to Choose Each Alternative?
So when should you use each of these types of loans?
Ultimately, it depends on your situation, needs and ability to repay the loan.
If you need income and can’t afford to make payments, a reverse mortgage may be the only option that doesn’t require you to make payments.
Thankfully, you can stay in the home as long as you follow the rules of the reverse mortgage without ever having to make a payment to pay back the loan.
Beware of the common pitfalls of reverse mortgages before you take one out. They often come with costly fees. They also require you to continue living in the home as your primary residence.
If you don’t follow the rules, you’ll have to pay off the reverse mortgage or sell the home to pay it off.
If you just need a temporary infusion of cash but can repay it later, a HELOC or home equity loan may be a better option.
This could happen if you retired early and are waiting to start getting payments from a pension. The solution will depend on whether you know how much money you need and when you need it.
A home equity loan may work better if you know how much money you’ll need in the future today. You can only take out money once and need to be able to make payments starting immediately.
A home equity line of credit may be the best option if you can start making payments in a few years or you aren’t sure how much money you’ll need during the draw period.
Using Your Home Equity for Retirement Income Isn’t Ideal
The reality is:
Using the equity in your home to fund your retirement generally isn’t a good idea.
Once your home equity runs out, you’ll no longer be able to tap this source of retirement income.
Depending on the option you chose, you may have to start repaying the debt. Then, the income may be gone and you could be stuck with monthly payments at the same time.
Choosing between a reverse mortgage vs. home equity loan or a HELOC is a tough choice.
If you’re forced to take out one of these options, weigh the pros and cons of each option carefully before deciding which is right for you.