Reverse Mortgage, Home Equity Loan, HELOC: What You Need to Know

Whether you're renovating your home, supplementing your retirement income or making big purchases, you have options to access money from your home equity.

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If your home has been appreciating in value and you've been making your mortgage payments consistently, and on time, you're probably sitting on a decent amount of equity. Whether you're thinking about tapping into that equity to help pay for a big home improvement project, supplement your retirement income or cover other major expenses, there are a few different ways to borrow against the equity you've accumulated.

As you compare your options, here's a rundown of what you need to know about the differences between a reverse mortgage, a home equity loan and a home equity line of credit, or HELOC

What is a reverse mortgage?

Appropriately named, a reverse mortgage operates in the reverse direction of a traditional mortgage. Instead of making payments each month to pay down your principal, you'll receive a check each month (there are also options to borrow in one lump sum), and you won't have to make payments until you sell the home or you die. This isn't for everyone, though. You need to be at least 62 years old to apply for a reverse mortgage. There are also different varieties of reverse mortgages: single-purpose, which restrict the way you can use the money; home equity conversion mortgages, or HECMs, which are insured by the federal government; and proprietary reverse mortgages, which can have higher limits than government-backed loans.

Pros

  • No immediate payments
  • Multiple options to receive funds -- monthly payments or one lump sum
  • Ability for a spouse to remain in the home for up to 12 months after you move to a health care facility or (in most cases) die

Cons

  • Adds to your debt
  • Comes with high closing costs, including origination fees of up to $6,000 and annual mortgage insurance premium
  • Potential for scams -- bad actors are known to target older homeowners
  • Can still lose your home if you fail to pay property taxes or homeowners insurance

Takeaway

If you're an older homeowner with a lot of equity -- at least 50% -- in your home, a reverse mortgage can be a smart pathway to accessing cash. These can come with serious consequences, though, for your spouse or what you pass along to your heirs, so it's important to do your research. You'll have to complete a homeownership counseling course if you take out an HECM (a reverse mortgage backed by the US Department of Housing and Urban Development), which can help answer your questions.

What is a home equity loan?

A home equity loan -- also often called a second mortgage -- lets you borrow based on the amount of equity you've accumulated in the home. Most lenders will only allow you to have a maximum outstanding mortgage debt of 85% of the value of the home (with some exceptions) between your first mortgage and the home equity loan. The loan is a fixed-rate loan, and repayment periods typically range between five and 30 years.

Pros

  • Fixed rate means your payments will never change
  • Money is distributed in one lump sum
  • Ability to deduct interest if you use the loan to improve your home

Cons

  • Must manage two mortgage payments, assuming you're still paying off your first mortgage
  • Potential to be underwater on your mortgage if your housing value declines significantly
  • Typically requires very good to exceptional credit (FICO score of 740 and above)
  • Putting your house on the line is always risky

Takeaway

If you have a firm number in mind of the amount of money you need to borrow, a home equity loan can be a good option. You'll need very good-to-exceptional credit to qualify for the lowest rates, though. 

What is a HELOC?

HELOC stands for home equity line of credit. While it has similarities to a home equity loan, a HELOC has a couple of key differences. First, it's a line of credit instead of one lump sum. So, you'll only draw funds as you need them during the so-called "draw period," which typically lasts for 10 years. Second, a HELOC has a variable interest rate that moves either up or down based on market conditions. Your payments will fluctuate as the rate adjusts. Like home equity loans, you're typically limited to a combined mortgage debt of 85% of your home's value.

Pros

  • Ability to make low payments that only cover the interest charges during the draw period
  • You can borrow as much money as you need
  • Often comes with a low introductory rate, along with potential interest rate discounts if you're an existing customer
  • Often comes with no closing costs
  • Some have the option to convert to a fixed rate, providing protection from rising interest rates

Cons

  • Variable rate can create unexpected surprises for your budget
  • Some lenders charge annual fees for a HELOC
  • Potential to lose your home if you can't afford to pay it back

Takeaway

A HELOC is a great fit if you aren't sure about how much money you'll need, and you have a financial cushion in your budget to withstand a payment increase when your rate goes up.

Reverse mortgage, home equity loan and HELOC


Reverse mortgage Home equity loan HELOC
Closing costs Yes, up to $6,000 of origination fees, plus other closing costs Varies -- often 2% to 5% of the loan amount Typically none
Age requirements Yes, must be 62 or older None None
Additional fees Annual mortgage insurance premium None Some lenders charge annual fees
How you can use the money Restrictions apply to single-purpose Any way you want Any way you want
Tax benefits
Interest isn't deductible until the loan is paid off partially or in full
Ability to deduct interest for home improvements
Ability to deduct interest for home improvements

Reverse mortgage vs. home equity loan

If you're older than 62 and trying to figure out whether a reverse mortgage or a home equity loan is a better fit, you'll need to think about one big question: Do you want to pay the loan back now, or would you prefer that your payments be delayed until you move or pass away? The other key consideration is the type of reverse mortgage you're hoping to use; if you qualify as a low- or moderate-income senior and want to use a single-purpose mortgage, you'll be restricted in how you can use the funds.

Home equity loan vs. HELOC

When comparing a home equity loan with a HELOC, the biggest question involves whether you want the comfort of a fixed-rate payment that will never change or you're OK with a variable rate. However, you might not have to choose. Some lenders are now offering the best of both worlds with HELOCs that allow borrowers to convert a portion or all of their loan from a variable to a fixed rate. Additionally, you'll want to think about how the closing costs on a home equity loan stack up against any annual lender fees on a HELOC. While the upfront costs might look overwhelming, those fees can add up over time on a HELOC, too.

Home equity loan vs. HELOC vs. reverse mortgage: Which one is best?

There isn't a simple answer when comparing a home equity loan versus a HELOC versus a reverse mortgage. Each one offers a different set of benefits for certain types of homeowners. As you compare your options for tapping into your home equity, consider this simple guidance to get started:

  • If you're an older homeowner with a large amount of equity, a reverse mortgage is likely your best bet.
  • If you want the stability of fixed payments and you know exactly how much you need, a home equity loan is probably the route to take.
  • If you aren't sure of how much money you'll need to spend and you're OK with changes in your monthly payments, a HELOC should be at the top of your list.

The bottom line

There are pros and cons to consider with home equity loans, HELOCs and reverse mortgages, but the most important lesson to keep in mind is that all of these will increase your debt and create a heightened risk of losing your home to foreclosure. Make sure you read the fine print to fully understand the fees you'll pay and the rules you'll need to follow to maintain good standing on your loan.