Reverse Mortgage vs. Home Equity Loan: Which Is Better?

Eligibility Criteria

Lenders look at your financial profile as part of their loan underwriting process for a home equity loan. They take into account factors such as your credit score, credit history, income, debt, and assets.

Reverse mortgage lenders consider your income, credit history, and age to calculate an expected term of the loan. You must be at least age 62 to qualify for a reverse mortgage. Even though the bank will make payments to the homeowner, the homeowner is still responsible to pay taxes and homeowners insurance.

Maturity

Home equity loans are for fixed terms, such as for five to 30 years. At maturity, the loan balance is zero.

Reverse mortgages, on the other hand, mature when the borrower dies or no longer lives in the home. At maturity, the balance is the original loan plus accrued interest.

Payments

Homeowners with a home equity loan make regular fixed monthly payments that include principal and interest.

In contrast, homeowners with a reverse mortgage receive regular monthly payments or can access a line of credit with a variable rate. They can also receive a lump sum with a fixed rate. They do not have to make regular payments back to the lender. Instead, the loan is repaid when the home is sold.

Loan-to-Value

Home equity loans are in addition to the existing mortgage. The amount available for a home equity loan is calculated as a combined loan-to-value (CLTV)

CLTV = (current mortgage balance + home equity loan balance) / appraised value

Most lenders require a CLTV of less than 80% for home equity loans.

The reverse mortgage loan-to-value limit is called the “principal limit.” The principal limit is calculated based on the age of the youngest borrower, interest rate, and value of the home. Home Equity Conversion Mortgages (HECM) are reverse mortgages offered by FHA-approved lenders and have a maximum loan limit of $970,800.

Mortgage Insurance

Mortgage insurance protects the lender if the borrower defaults on the payments. Mortgage insurance is usually not required for home equity loans.

FHA-approved HECMs require mortgage insurance for all loans. The mortgage insurance protects the homeowner if the bank defaults on the payments.

HECM mortgage insurance also protects the borrower if the home is sold for less than the balance of the mortgage. The premiums are 2% of the loan initially, then 0.5% of the loan balance annually. Reverse mortgages that are not from FHA-approved lenders, or proprietary reverse mortgages, may not require mortgage insurance.

Special Considerations

FHA Guarantees

The Federal Housing Administration (FHA) guarantees mortgages for approved lenders. If the borrower defaults, the FHA pays the lender.

To qualify you must:

• Be 62 years of age or older
• Own the property outright or have a small mortgage balance
• Occupy the property as your main residence
• Not be delinquent on any federal debt
• Participate in a consumer information session given by an approved HECM counselor

Counseling

Reverse mortgages can be complicated. The FHA requires potential HECM borrowers to attend a counseling session before the lender can issue a loan commitment. The counseling covers:

• Features of a reverse mortgage
• Client responsibilities under a reverse mortgage
• Costs to obtain a reverse mortgage
• Financial/tax implications of a reverse mortgage
• Financial or social-service alternatives to a reverse mortgage
• Warnings about potential reverse mortgage/insurance fraud schemes and elder abuse

Estate implications

Home equity loans usually contain a “due on sale” provision. If the property is sold, or ownership is otherwise transferred, including at death, the loan becomes payable in full. HECM reverse mortgages are payable in full at the death of a surviving spouse.

The Bottom Line

Home equity and reverse mortgages are both ways to unlock home equity, but reverse mortgages offer more protections to seniors. Seniors can use reverse mortgages to access equity without obligations to make payments. Seniors are also protected by mortgage insurance if the home is sold for less than the loan balance, as long as the sale price is at least the market appraised value.

Reverse mortgages are complex financial products. If you are considering one to supplement your retirement plan, be sure you understand how it works and how it may affect your family in the future.

If you want to tap your equity but you aren’t 62 or older, a home equity loan, home equity line of credit, or refinancing the mortgage are alternative options.

Frequently Asked Questions (FAQs)

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