Reverse Mortgage vs. Home Equity Line of Credit (HELOC): Which Option is Best for Tapping Into Your Equity?
By: Review Counsel Staff
October 21, 2024 • 7 minute read
As the equity in your home increases, it opens up the opportunity to take advantage of that wealth you are growing. And there are several ways to do that without having to sell your home.
Two options to consider for turning that equity into cash are a reverse mortgage and a home equity line of credit (HELOC).
But which one should you choose? In this article, we are going to learn the similarities and differences between a reverse mortgage and a HELOC, how they work, and what scenarios would make one a better option over the other.
Let’s dive in.
Reverse Mortgage: What is it and How Does it Work?
A reverse mortgage is a loan just like your current mortgage, but the way a reverse mortgage works is very different.
A reverse mortgage is also known as a Home Equity Conversion Mortgage (HECM). When you take out a HECM reverse mortgage, it will pay off your current mortgage if your home is not already paid off. This also means that you will no longer have to make monthly payments toward your original mortgage.
Next, the reverse mortgage will convert your remaining equity into cash. You will have the option to receive the funds as a lump sum, monthly payments, a line of credit or a combination of the three.
A reverse mortgage is not paid back with monthly payments like a traditional mortgage. It is paid back when the home is sold, when the home is no longer the primary residence, or when the last homeowner becomes deceased.
This is typically done through the proceeds from the sale of the home.
How Do You Qualify for a Reverse Mortgage?
Not just anyone can take out a reverse mortgage. In order to qualify, you must meet several very specific requirements including the following:
- At least one of the homeowners must be 62 years of age or older
- The home must be paid off or have some equity built up (typically a minimum of 50%)
- The home must be maintained
- The homeowners must be current on the property taxes and homeowners’ insurance
Before homeowners may officially file an application for a reverse mortgage, they must first complete a counseling session with a HUD-approved counselor.
Once the reverse mortgage is obtained, the borrowers must continue to maintain the home, pay property taxes, and homeowners’ insurance.
Why Choose a Reverse Mortgage
One of the reasons a reverse mortgage may be good option for homeowners who meet the requirements is the flexibility it offers. Because of the different ways the funds can be received, it is not just a one-size-fits-all option.
Here are some of the ways the funds from a reverse mortgage can be used:
- Round out your retirement portfolio. If you are in or heading into retirement and find that you don’t have the retirement savings to maintain your current standard of living, and you own your home, a reverse mortgage may be the solution.
- Supplement Social Security payments. If you find that your Social Security payments are not enough to make ends meet, a reverse mortgage can give you additional monthly income if you opt to receive the funds as monthly payments.
- Make major home renovations. If you would like to update your home to serve you better in your retirement and you don’t have the savings to cover the necessary costs, receiving the funds in the form of a lump sum could help offset the upgrades. In addition, upgrading your home can also help increase the value of your home.
- Emergency fund. If you find you don’t have significant savings set aside for unexpected expenses or emergencies, you may opt to receive your reverse mortgage funds as a line of credit so it’s available if or when you need it.
- Live your dream retirement. If all your monthly expenses are covered, your home is updated to your liking, and you have an emergency fund saved up, you may simply want the additional funds from a reverse mortgage to travel and visit friends and family more often.
If a reverse mortgage sounds like the right option for you, it’s important to note that if it is something that you think you would like to do, you may want to move forward on it as soon as you are sure. The reason why is that the reverse mortgage loan process is not a fast process. It can take up to 45 days before you receive your funds.
If you decide at some point during the process that you don’t want the reverse mortgage, you can cancel at any time including three days after you sign the closing loan documents.
HELOC: What is it and How Does it Work?
A Home Equity Line of Credit (HELOC) is considered a second mortgage. It is a line of credit that works similar to a credit card. Homeowners are able to withdraw from the account, pay it back, and then continue to borrow from the same account.
When you take out a HELOC, your home is used as collateral for the funds. This also means that if you fail to make the required payments, it could result in your home going into foreclosure.
HELOCs are received with a variable interest rate. The credit limit you are given depends on how much equity you have available. While the amount you may borrow may vary from lender to lender, homeowners are typically able to borrow up to 85% of the home’s value after the mortgage balance is accounted for.
HELOC borrowers are able to use the funds through a credit card linked to the HELOC account or through checks. In most cases, the draw period is 10 years.
Homeowners are required to make monthly interest payments on the amount borrowed. Funds that aren’t used do not incur interest.
Once the 10-year draw period is over, the repayment period begins. Typically, homeowners will have 10 to 20 years to repay the balance. Borrowers are allowed to start repaying the principal balance before the draw period is over.
A HELOC can be used for any purpose including home upgrades, paying for a wedding, funding college tuition, or simply an emergency source of funds.
How Do You Qualify for a HELOC?
HELOCs do not come with an age requirement like a reverse mortgage, which means it’s more widely available to homeowners, but there are some requirements that are necessary in order to qualify for one.
Please note that requirements may vary from lender to lender, but these are some minimum requirements you can expect:
- Have a minimum of 15% to 20% equity. In most cases, you will need at least 15% equity built up in your home, but 20% is generally preferred. The value of the home will be assessed during the application process by an appraisal.
- Have a minimum credit score of 620. While 620 is the minimum, higher is better. If you want to qualify for the best rates, you will want a credit score of 720.
- Have a 50% or lower debt-to-income ratio. A debt-to-income ratio of 50% is typically the max that lenders will want. This is determined by adding all monthly debt payments then dividing that total by your monthly income.
- Pay your bills on time. You will also have a better chance of getting approved for a HELOC if you have a history of paying your bills on time.
Why Choose a Home Equity Line of Credit
A HELOC is a good option for someone who wants the flexibility of a line of credit, they only need the money for a limited time, and they are able to make the interest payments.
This makes it ideal for someone who knows they will want to make continuous withdrawals to fund a variety of projects or for someone who doesn’t know exactly how much they will need.
The borrowers also need to be able to pay it back when the draw period is over.
Which Should You Choose?
If you meet the qualifications for both a reverse mortgage and a HELOC, the decision comes down to what your needs are.
If you are looking for a way to access your equity while eliminating monthly mortgage payments, then a reverse mortgage may be the way to go.
If you simply want a line of credit and you are able to afford the interest payments and you are able to pay it back when the draw period is over, then a HELOC may be the right choice for you.
The next step is to talk to a reverse mortgage or HELOC lender.
If you are interested in pursuing a reverse mortgage, check out our list of recommended reverse mortgage lenders.
If you are interested in pursuing a HELOC, check out our list of recommended mortgage lenders.
| Reverse Mortgage | HELOC |
|---|---|
| Eliminates monthly mortgage payments | Requires monthly interest payments on funds used |
| Receive funds as lump sum, monthly payments, and/or line of credit | Must be paid back when the draw period is over |
| Use money for any purpose | Use money for any purpose |
| Don’t pay back as long as you live in and maintain the home | Revolving source of funds (if it is replenished during the draw period) |
| Replaces current mortgage (so you only have one mortgage) | Second mortgage |
This information is intended to be general and educational in nature and should not be construed as financial advice. Consult your financial advisor before implementing financial strategies for your retirement.
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