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How does a reverse mortgage compare to a home equity loan?

Home equity loans and reverse mortgages are two readily available options you can use when you need to access cash. While similar, both come with very different terms and conditions. Here is a brief overview of the differences to help you understand which home financing options are the right fit for you.

Anita Chauhan
December 16, 2021
Blog overview

What is a reverse mortgage?

Understanding the different reverse mortgages 

Getting approved for a reverse mortgage

Risks of a reverse mortgage

Is there a reverse mortgage alternative?

What is a home equity loan?

How to get approved for a home equity loan

Risks of a home equity loan

Which option is right for you?

Home equity loans and reverse mortgages are two financing options you can use when you need to access cash. While similar, both come with very different terms and conditions. 

Here is a brief overview of both reverse mortgages and home equity loans to help you understand which home financing options are the right fit for you. 

What is a reverse mortgage?

Reverse mortgages are a common way to dip into your home's equity. These loans have tight age restrictions and are limited to homeowners aged 62 or older who have amassed a considerable amount of home equity. These loans are secured against the value of your home.

Reverse mortgages allow the homeowner to access additional, tax-free cash flow by tapping into the equity they have built up in their homes. You receive a lump sum cash payment and typically do not require monthly payments.

Due to the lack of monthly payments, homeowners must pay back the entirety of their loan when they move, sell their home or pass away. Homeowners looking to repay their reverse mortgage in full before the end of the term will typically be required to pay prepayment penalties on top of the original amount and accrued interest. 

Finally, reverse mortgage interest rates tend to vary. Most of these products do not have a cap, leaving you and your hard-earned equity open to market fluctuations.

Understanding the different reverse mortgages 

Reverse mortgages come in three different forms. Here is what you should keep in mind when shopping around for a financial solution that fits your needs.

This type of financing comes with advantages and disadvantages that you and your loved ones should consider before signing any contracts.

Home equity conversion mortgages (HECMs)

This type of reverse mortgage is the most widely used. HECMs are insured by the Federal Housing Administration (FHA), a division of the U.S. Department of Housing and Urban Development (HUD). HECMs can be used for any need and are guaranteed by the government. 

Due to their federal backing, home equity conversion mortgages require you to undergo counseling before signing the final agreement. 

Single-purpose reverse mortgage

The single-purpose reverse mortgages are the least expensive of the three types. 

These reverse mortgages do not come with federal backing, can be more rigid, and typically are only used for a purpose the lender specifies. The purpose can vary and include things such as:  

  • home repairs
  • home improvements
  • Paying down property taxes

Single-purpose reverse mortgages are not available everywhere. Although the FHA does not insure them, they can still be found by various state and local governments, and even some non-profits.

Proprietary Reverse Mortgage

The last type of reverse mortgage is the proprietary reverse mortgages. Private companies offer this mortgage and aren't backed by the FHA.
 

Getting approved for a reverse mortgage

Reverse mortgages are unique in that they come with age restrictions. They are a popular option for homeowners, 62 years of age or older, with considerable home equity. If you have paid down your mortgage and own most of your home, reverse mortgages may be a good fit. 

During the approval process, lenders will consider several factors before approving your application. These factors include a recent home appraisal and an income assessment to ensure you can maintain your home and pay homeowners insurance, property taxes. 

Since the age restriction for reverse mortgages is 62+, most people who take these loans out are retirees on a fixed income. Not to mention, that for many, their home is typically their most significant asset. Before signing anything, homeowners must understand the risks associated with any reverse mortgage product.

To help educate borrowers, the U.S. Department of Housing and Urban Development (HUD) requires you to undergo counseling with a HUD-approved agent. This ensures that you understand all aspects of the loan before committing. Through the process, the HUD-approved agent will also educate you on alternative financing options such as home equity investments, home equity lines of credit (HELOCs), and home equity loans. 

What are the risks of a reverse mortgage?

Before taking on any home financing of any kind, it's helpful to understand your situation and needs and if a reverse mortgage is right for you. 

Many homeowners have been the target of reverse mortgage scams, so be informed of the risks and red flags you may encounter before committing to anything. Protect yourself by not engaging with any unsolicited advertisements or calls. Reduce risk by seeking out your HUD-approved counselor or lender.  Protect yourself by not responding to any unsolicited advertisements and seeking out your lender and HUD-approved counselor before signing any agreements.

Photo by Scott Webb on Unsplash

There could be many reasons that your entire mortgage amount could come due, meaning that you would need to be ready to pay back the amount in full. Here are some other things to keep in mind before committing to a reverse mortgage.

1. Know how long you plan to stay in your home. Due to the upfront and closing costs, reverse mortgages tend to be more expensive than other alternatives. If you plan to move soon, taking on a reverse mortgage may not be the best option. 

2. Check-in with your health. If you have any health issues or impending medical needs that will require you to move to an assisted living facility or a long term care home for an extended (12+ month) period, you could trigger a repayment of the mortgage as your primary residence will change in the eyes of the lender. 

3. What is your living situation? Before taking on a reverse mortgage, understand who you will include on the loan paperwork. If you live with anyone under 62 who won't be on the paperwork, be aware that they would be held responsible for the loan repayment if you were to pass away. This will be the responsibility of your loved ones once you pass away and may require them to pay the lender back in full or sell the home.

4. What is your timeline? If you have an urgent need to access the funds, you may be held up in the application process, delaying access to your lump-sum payment.

To facilitate a smooth process, ensure that your reverse mortgage lender is licensed to offer reverse mortgages (not all banks are). Account for any time needed to complete paperwork, your financial assessment, and the counseling session with HECM.

Is there a reverse mortgage alternative?

Reverse mortgages can be a good fit, depending on your situation. Still, there are alternative options in many cases that will put you in a better position in the long run. 

Reverse mortgages are not the only way to access your home equity to access cash. Depending on your needs, home equity lines of credit (HELOCs), home equity loans, and cash-out refinancing could be better options for you. When making a final decision, account for interest rates and prepayment penalties - there could be options for you that are fairer and more suited to your specific situation. 

Let's dive into one of the most popular alternatives to reverse mortgages, the home equity line loan. 

What is a home equity loan?

Home equity loans are a common and accessible way to access a large lump sum of money. Commonly referred to as a second mortgage, these loans lend homeowners a large sum of money tied to their home equity at a fixed interest rate.

Home equity loans are typically offered for 30-year terms. Homeowners are expected to pay down the loan and any accrued interest in monthly instalments over those 30 years.

This is an ideal offering for homeowners who have paid off a large amount of their original mortgage and have good credit. 

How to get approved for a home equity loan

The process for a home equity loan comes with stringent income considerations. Since home equity loans require monthly repayments, applicants must meet specific income requirements before being approved.

Lenders will have to ensure that the homeowner has sufficient means and a documented ability to repay their loan.

Homeowners applying for this financing must provide details on their source of income, credit history, and overall debt-to-income ratio. Applicants who are not fully employed or have non-traditional sources may need additional documentation to show that they can fulfill payment obligations over the term. 

An additional consideration includes your credit score. Home equity loans require a lower minimum score than other financing options. Still, they can come with higher than average interest rates as a result. The better your credit score, the higher the chances of qualifying for a more reasonable rate. The lower your score, the higher the rates. 

Risks of a home equity loan

Similar to reverse mortgages, these loans come with advantages and disadvantages.  Even if you have a good credit history and have paid down existing mortgages and loans, it's important to remember that home equity loans are still that: loans. Before committing to any loan, homeowners must review their options and have a budget for monthly payments and a plan for paying back their loan.

With a home equity loan, you are using your home as collateral. Without preplanning and understanding what you are signing up for, missing a monthly payment could mean risking your home. 

Interest can add up quickly, and even if monthly payments are feasible for you, the overall costs could amount to more than you can afford over the long term. Before committing to any financing that has accrued interest, it is important to calculate your total interest costs over the term of your loan. 

When choosing home equity financing, consider any prepayment penalties. If you choose to pay off your loan earlier than the term end, you may be charged a prepayment penalty which could be anything from 0.1%-20% of the loan depending on the terms. If, say, one day you have extra money to spare and can pay off your loan in full, you could be charged with exorbitant fees amounting to more than you initially signed on for. Along with your overall interest amount throughout the home equity loan, make a note of any prepayment. 

If you're considering a home equity loan, it's worth asking your lender what prepayment penalty they charge before finalizing your financing agreement.

Which option is right for you?

No one can decide for you - when it comes to your finances, you have to choose what works best for you and your family. Home financing has upsides and downsides, and traditional offerings have been predatory and opaque. When choosing a financing option for your unique needs, you should always consider:

  • Your current situation (Will you be moving soon? What is the worst-case scenario? What is the best? 
  • How will you make monthly payments? 
  • What does a flexible repayment schedule look like? 
  • What terms work for you? 
  • What interest rates are available
  • What happens if you decide to repay the loan earlier? 
  • Does the lender have your best interests in mind? 

A reverse mortgage may be right for you if you're retired, on a fixed income, or rely on government assistance, and if you are not planning on leaving your home to a loved one when you pass.

On the other hand, a home equity loan could be ideal if you need an upfront lump sum. This cash infusion is suitable for those who need help to start a small business, pay off large, expected bills, or even renovate their home. This is also contingent on your ability to make monthly payments.  

There is also another alternative option: the Fraction Mortgage. Unlike a typical HELOC or home equity loan, the Fraction Mortgage allows you to safely access up to a percentage of your home's equity at a fair rate with no required monthly payments.* Fraction offers you a lump sum amount that you can use to save for retirement, help your loved one save for a downpayment, or invest in long-term healthcare insurance. When you work with Fraction, you owe nothing for up to 5 years.

No matter what you choose: selling your home, refinancing, or paying Fraction back, you never have to worry about prepayment penalties. 

The Fraction Mortgage rate is based on the appreciation of your home with minimum and maximum rate caps. View our latest rates here.

See how Fraction compares to other options here.

Unlock up to $1.5 million in cash by submitting a free home estimate today. Fraction's team is here to guide you from application to commitment letter, with your funds being available to you within 20 days.