Home equity loan vs. reverse mortgage: How to choose

Your home doesn’t just provide you with shelter and a place to make lasting memories. It also helps you build equity that you can use to pay off high-interest debt, supplement your income, renovate your residence, or achieve other significant goals.

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There are several ways to tap into your equity, including a home equity loan and a reverse mortgage. While both can put the money you need in your pocket, they function very differently. We’ll share the essential details you need to know so you can choose the financial product that works best for your current circumstances and future wishes.

How does a home equity loan work?

Often called a second mortgage, a home equity loan runs concurrently with your primary mortgage. You receive a lump sum payment and can use the cash for any purpose, including debt consolidation, property upgrades, medical bills, or a dream vacation. You can also use a home equity loan to supplement your retirement savings.

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You’ll be on the hook for closing costs, which are typically two to five percent of the loan amount.

How does a reverse mortgage work?

With a traditional mortgage (sometimes called a forward mortgage), you submit monthly payments to your lender until your debt is repaid or you sell your home. As the name implies, with a reverse mortgage, the money flows in the opposite direction.

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Your lender will pay you in exchange for an ownership stake in your residence. You can remain in your home until you pass away, move, or sell the property.

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There are three types of reverse mortgages:

• Home Equity Conversion Mortgage (HECM): An HECM is likely what you imagine when you think about reverse mortgages. You can use the funds for any purpose.
• Single-Purpose Reverse Mortgage: With a single-purpose reverse mortgage, your lender will issue the loan if the funds get used for one agreed-upon purpose, such as aging-in-place remodeling. The single-purpose reverse mortgage is subject to conforming loan limits.
• Proprietary Reverse Mortgage: If you need a loan exceeding those limits, a proprietary reverse mortgage from a private lender could be the right option.

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Since the HECM is the most popular reverse mortgage, we’ll focus on it for the remainder of the article. The loan is insured by the federal government and issued by a Federal Housing Authority (FHA)-approved lender.

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The amount you can borrow is determined by your age, your home’s value, and the loan’s interest rate. An HECM is also subject to conforming loan limits. You may receive funds as a lump sum, in regular installments, or as a line of credit and can use the money to cover any expense.

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The reverse mortgage application process can be lengthy due to the mandated counseling sessions. You can also expect to pay a loan origination fee at closing (capped at $6,000) and mortgage insurance premiums (two percent of the loan amount upfront and 0.50% annually). In addition, you may have to cover third-party costs, like appraisal and inspection fees, and pay a monthly loan servicing fee of up to $35.

Home equity loan vs. reverse mortgage: Key differences

Qualification requirements

Home equity loan

A home equity loan typically allows you to borrow up to 85% of your home’s value, requiring you to have at least 15% equity in the property. (Your equity is how much the house is worth minus your current mortgage balance.)

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Generally, it’s hard to qualify for a home equity loan with bad credit; you need a good to excellent credit score (680+) and steady, verifiable income (debt-to-income ratio of 43% or less) to be eligible.

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Reverse mortgage

On the other hand, with a reverse mortgage, you must be 62 or older, own your home outright (or owe very little on your mortgage), and plan to use your house as a primary residence to qualify.

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In addition, your home must be well-maintained, insured, and up to date on its property taxes. You must also complete financial counseling sessions conducted by a Department of Housing and Urban Development (HUD)-approved agency.

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Typically, you won’t need to meet specific credit score or income requirements for a reverse mortgage. However, your lender may confirm that you have sufficient resources to cover your homeowner’s insurance premiums and property taxes moving forward. Plus, you can’t be delinquent on any federal debt.

Time to fund

Both processes work similarly; you apply, get a home appraisal, and then the lender determines your eligibility. However, both products have different application timelines. A home equity loan typically takes two to four weeks, while a reverse mortgage takes four to six weeks.

Loan conditions

Home equity loan

Like your primary mortgage, a home equity loan uses your property as collateral. That means your lender can foreclose on your house if you default on the debt.

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Reverse mortgage

If you stop meeting the reverse mortgage’s eligibility requirements, such as maintaining property insurance, paying property taxes, keeping up with home improvements, or residing in the home, your lender could require full and immediate repayment. If you’re unable to pay, the lender can foreclose on your home.

Repayment

Home equity loan

With a home equity loan, you can expect to start making monthly principal and interest payments almost immediately after closing day. Loan terms can range from five to 30 years.

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Generally, home equity loans feature a fixed rate, making it easier to plan for the expense over time. You may be able to write off the interest you pay on your loan if you itemize your deductions and use the funds to renovate your home.

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Reverse mortgage

You can choose to make monthly interest payments on your reverse mortgage. Doing so will limit the amount you or your heirs will owe when the mortgage ends. However, you’re not usually required to make any payments until you move, sell the home, or pass away.

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A lump sum disbursement has a fixed rate, while all other pay-out options have a variable interest rate. The payments you receive from your lender are tax-free income. Plus, you may be able to deduct any interest you pay on your income tax return.

Impact on inheritance

Home equity loan

If you pass away while holding a home equity loan, your heirs can use funds from your estate to pay off the balance and keep the property. If there’s not enough money to cover the debt, your loved ones will either need to come up with the difference or sell the house to satisfy the lender.

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Reverse mortgage

With a reverse mortgage, your heirs can also repay the loan and retain ownership of the residence. But, typically, they will give your lender your home’s title or sell the property to settle the debt.

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If you’re married, your spouse can continue living in the home. However, they won't keep receiving reverse mortgage payments if they’re not listed as a borrower on the note.

Reverse mortgage vs home equity loan: Which is right for you?

Deciding which loan product is right for you can be challenging. Let’s break it down.

When is a home equity loan a good idea?

A home equity loan could be right for you if you:

• Are under age 62
• Have good credit, solid income, and sufficient equity
• Want to borrow a lump sum at a reasonable, fixed interest rate
• Need many years to repay the debt
• Would like to leave the property to your heirs eventually
  

When is a reverse mortgage a good idea?

A reverse mortgage may be a good idea if you:

• Are age 62 or older
• Plan to reside in the house indefinitely
• Need to supplement your income
• Want to avoid making monthly payments
• Can cover insurance premiums, maintenance costs, and property taxes
• Like the idea of receiving funds in installments or as a line of credit
• Don’t have heirs poised to take ownership of the property upon your death
  

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Final thoughts

We put the home equity loan vs. reverse mortgage head-to-head and found that they are both viable options for tapping into your home’s equity. However, if neither seems like the best fit for you, consider a Home Equity Investment (HEI).

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With an HEI, you receive a lump sum of cash in exchange for a share of your property’s future appreciation. An HEI functions similarly to a reverse mortgage in that you don’t have to meet strict financial criteria, won’t need to make monthly payments, and can stay in your home.

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However, it shares some of the perks of a home equity loan in that you don’t need to own your home outright, be a specific age to qualify, or have strict conditions to follow.