FINANCIAL WELLNESS

How Does a Reverse Mortgage Compare to a Home Equity Loan?

By - Nov 20th, 2020
Reverse mortgages and home equity loans are two popular options to convert your home equity to cash, but the financing terms are quite different.  Let's break down those differences so that you can decide which type of home financing is right for you.
What is a Reverse Mortgage?
Reverse mortgages are loans available to homeowners age 62 and older who have a considerable amount of home equity. Secured against the home, reverse mortgages allow the homeowner to create additional cash flow for themselves using the equity they’ve built up over time in either a lump sum or in monthly payments. One benefit of a reverse mortgage is that they typically don't require any monthly payments. Instead, the entire loan then becomes due when the homeowner moves, sells the home, or passes away – an important distinction for you and your family to consider before signing the dotted line on this type of financing.
What are the 3 Types of Reverse Mortgages?
There are three different types of reverse mortgages you should know about when considering a lender:
Home Equity Conversion Mortgages (HECMs)
Most reverse mortgages today are HECMs, which are insured by the Federal Housing Administration (FHA), a part of the U.S. Department of Housing and Urban Development (HUD). These federally backed loans can be used for any purpose.
Single-Purpose Reverse Mortgage
Unlike HECMs, single-purpose reverse mortgages are not federally backed and can only be used for a purpose the lender specifies, such as home repairs, home improvements, or property taxes. These reverse mortgages are offered by some state and local governments as well as select non-profits, but they are not available everywhere. Of the three types of reverse mortgages, single-purpose reverse mortgages are typically the least expensive.
Proprietary Reverse Mortgage
Proprietary reverse mortgages are offered by private companies. These loans are not backed by the FHA and are typically designed for borrowers with high home values.
Getting Approved for a Reverse Mortgage
Unlike other types of home financing, reverse mortgages are restricted by age:  you must be at least 62 years old to take out a reverse mortgage.  Generally, the more equity you own in the home and the older you are, the more likely you will be approved for a reverse mortgage.  Other factors a lender will consider when reviewing your application include an updated home appraisal and a financial assessment to evaluate your ability to keep up with property taxes, homeowners insurance, and other homeownership-related expenses. Home equity conversion mortgages (HECMs) are one of the only financial products in the U.S. that require counseling before you sign the final agreement.  Because a reverse mortgage could fully cash out what is likely your largest asset – your home – the U.S. Department of Housing and Urban Development wants to ensure that homeowners are fully informed about their options before committing to a reverse mortgage.  Especially because a large majority of those considering these loans are retirees on a fixed income.  During the application process, a counseling session with a HUD-approved agent will ensure you fully understand the implications of the loan as well as educate you on alternative financing options like home equity investments, home equity loans and HELOCs.
Risks of a Reverse Mortgage
The most important thing to think about when considering a reverse mortgage is your homeownership horizon. Knowing that there are multiple instances in which the entire loan would become due, it's worth asking yourself:
  1. How long do you intend to stay in your home?  If you see yourself moving anytime soon, the upfront costs of a reverse mortgage may not be worth it – closing costs for reverse mortgages can be much higher than alternative options.  

  2. Do you have anticipate any health issues that could require you to locate to a care facility?  Under reverse mortgage regulations, residency at a nursing home or assisted living facility for more than 12 consecutive months would qualify as the borrower's primary residence.  This would cause the reverse mortgage to become due.

  3. Do you live with other family members? If you live with anyone who won't be on the loan paperwork (or anyone who is under the age of 62), should you pass away, they would be forced to either come up with the means to pay the lender back or sell the home.

  4. And - how quickly do you need the funds?  Application requirements may end up pushing back your timeline if you’re not prepared for the time investment.  Plan to do your research, make sure your lender is licensed to offer reverse mortgages (not all banks are), and budget time to complete your HECM counseling session (if applicable) and financial assessment.

As reverse mortgages gained popularity in the early 2000's, scams in which older homeowners were targeted with fraudulent reverse mortgage products also increased.  If you're seeking out a reverse mortgage, protect yourself by not responding to unsolicited advertisements and to seek out your own lender and HUD-approved counselor before signing any agreements.
Is There an Alternative to a Reverse Mortgage?
If you're asset-rich but cash-poor, a reverse mortgage is just one of many types of home financing that may allow you to convert your home equity into cash. Home Value Investments, home equity lines of credit, cash-out refinancing, and home equity loans are all worthwhile options to consider, depending on your personal financial goals.
What is a Home Equity Loan?
Sometimes referred to as a second mortgage, home equity loans allow borrowers to access their home equity in exchange for a lump sum cash payment with a fixed interest rate. Repayment generally happens over a 30 year time period, where the homeowner repays the loan amount in monthly installments that include accrued interest. These loans are one of the most common forms of home financing for homeowners with good credit who have paid down a significant portion of their primary mortgage.
Getting Approved for a Home Equity Loan
Because a home equity loan requires monthly payments, one of the most important things a lender will look for when they review your application is a documented ability to repay your loan.  They'll analyze your source of income, your credit history, and your debt-to-income ratio.  If you are not a W2 employee and have a non-traditional income source, you may have to provide additional documentation to prove that you have the ability to make your monthly payments over the term of the loan.   While the minimum credit score requirement is lower for home equity loans than some other forms of financing, it will affect your interest rate.  The higher your credit score, the more likely that you'll qualify for the best rates.
Risks of a Home Equity Loan
While home equity loans are a good option for borrowers with a spotless financial record, it is still a secured loan. Without a solid plan for how you’ll use the money and how you’ll budget for your monthly payments, you could find yourself missing payments and putting your property at risk of foreclosure. Before taking out a home equity loan, or any type of home financing with accrued interest, it’s also worthwhile to calculate your total interest costs over the length of the loan. Interest can add up quickly – especially when considering a 30 year loan. Interest is how lenders generate revenue, so if you someday come into a windfall or are otherwise able to pay off your loan earlier than planned, some lenders may offset the lost interest revenue by charging you a prepayment penalty (anywhere from 0.1%-20% of the loan). If you’re considering a home equity loan, it’s worth asking your lender what prepayment penalty they charge before finalizing your financing agreement.
So Which is Better: a Home Equity Loan or a Reverse Mortgage?
Personal finance is personal – only you can make the decision about what type of home financing is the best for you and your family's situation. When evaluating the differences between a home equity loan and a reverse mortgage, the main aspects to focus on are how you receive the funds and the loan repayment schedule.   If you're in need of steady income to supplement your social security or other retirement income and aren't planning to leave your home to your children, a reverse mortgage may provide the steady check you need to cover your living expenses.  But if you're looking for a large lump sum in order to achieve a goal like completing home renovations or starting a small business, a home equity loan may be the better choice for you – provided you're able to absorb the monthly payments.  However there is another option you should consider:  A Home Value Investment.
Why You Should Consider a Home Value Investment
If the lump sum payment structure of a home equity loan appeals to you, but there's no other room in your budget for another monthly payment, a Home Value Investment may also be worth consideration.   An alternative to home loans, a home equity investment or Home Value Investment is an innovative type of home financing that doesn't add to your debt load.  Home equity investors like Noah provide upfront financing that allows you to cash out of a portion of the equity in your home, while completely eliminating monthly payments and added interest.  In exchange for the investment, you allow Noah to share in a portion of the future value of your home.  You have up to 10 years to buy out Noah’s investment, whether you sell, refinance, or pay us back another way, without the worry of prepayment penalties if you're able to repay our investment sooner than planned.  Homeowners like Home Value Investments because they aren't considered a loan or debt- and therefore doesn't appear on their credit reports or add burdensome monthly payments. Get a free quote for up to $350,000 in upfront funding from Noah today, without any impact to your credit score.  Noah's Home Advisory team will guide you through the application process every step of the way, with funds in your bank account in as little as 15 days.