Home Equity Loans vs. Reverse Mortgages
Comparing two financing options that access valuable home equity.
A home is the most valuable asset most consumers own long term. Unlike other items you purchase that lose value over a period of time, real estate value increases from the time of purchase. This increased value is called equity.
It’s the difference between the fair market property value and the remaining balance on your mortgage. This means as you pay down the mortgage, you gain equity. Loans like home equity loans and reverse mortgages allow you to access this equity to improve your financial outlook.
Taking out an equity loan of any kind is a serious financial decision. If you’re considering a home equity loan or a reverse mortgage, talk to a counsellor before you apply. Call Consolidated Credit today at 1-844-402-3073 to speak with a counsellor for free. You can get professional advice on how new financing will affect your home, mortgage and overall financial outlook.
How do Home Equity Lines of Credit Work?
A home equity line of credit allows you to access the equity you’ve built up in your home. In a normal housing market, the value of a property will increase slowly over time. Even if you don’t live in an up-and-coming market, regular inflation usually means a home is worth more with each passing year.
It’s important to note, this is only true in a normal market. In a weak market home values can decrease. When you have a market collapse like the one seen in 2008, property values can drop significantly.
Assuming your home is worth more now than when you purchased it, there is accessible equity in your home. An equity line of credit lets you access this money to improve your financial outlook in the short term. A reverse mortgage also allows you to take advantage of home equity.
How is a Reverse Mortgage Different from a Home Equity Loan?
Reverse mortgages are not exactly the same thing as a standard home equity loan. They are specifically geared to help seniors access equity in their homes. As such, reverse mortgages have a specialized lending process, more targeted qualifications and a different repayment schedule than home equity loans. In some part, these safeguards are put in place to help protect seniors using reverse mortgages.
In order to use a reverse mortgage:
- Homeowners for the property must be age 55 or over.
- All homeowners must apply for and sign the reverse mortgage papers
- At least one homeowner must reside in the property as a primary residence. (That means living in the home at least six months a year.)
- You must own your home free and clear. (If you have an existing mortgage on your home, the reverse mortgage can be used to pay off that mortgage and any other secured debts.)
- You must complete a reverse mortgage counselling session before getting your loan.
In addition, once you get your reverse mortgage, you don’t pay anything back every month. In fact, no money is due on the loan until the last homeowner on the deed passes away or moves out of the residence.
By contrast, a standard home equity loan is available to anyone, regardless of age. There is no residence restriction and you don’t even need to take a course or undergo any kind of counselling before you take out the loan and get your money. You also start to pay the loan back immediately, just like you do with other lines of credit.
Why You Might go with a Reverse Mortgage over a Home Equity Loan
Reverse mortgages are worth considering if you meet the minimum age requirements (55 years old in most cases) and you have a home in a marketable area and you’ve built up substantial equity.
The reverse mortgage business has been booming in recent years. Due to the aging baby boomer population, the number of reverse mortgages has nearly tripled over the last five years, according to statistics from the Office of the Superintendent of Financial Institutions, with no signs for slowing down.
With a reverse mortgage you have the option of receiving a lump sum or having the amount spread out over several years in smaller payments.
The amount you qualify for by way of a reverse mortgage depends on several factors. Those include your age, where your home is located, your home’s property type, your gender and how many people live in the home.
Generally speaking, the older you are, the more money you can typically access as a reverse mortgage. If you’re only 55 years old, you may only be able to access 15 to 20 percent of your home’s value as a reverse mortgage. You usually need to be at least 80 years old to access the maximum amount as a reverse mortgage.
How the real estate market is performing also affects how much you can access as a reverse mortgage.
At first glance going with a home equity loan over a reverse mortgage may seem like a no brainer. Home equity loans traditionally have lower interest rates than reverse mortgages, so it’s case closed, right? Not quite so.
The fact of the matter is that a lot of seniors are on fixed incomes. These seniors may have a high net worth on paper, but most of their net worth is trapped in their home. They may earn limited income from government benefits and investments. This makes it difficult to qualify for a home equity loan, since the lender will want you to qualify based on your income. This is where reverse mortgages come in handy.
Unlike a home equity loan, there’s little to no proof required when applying for a reverse mortgage. That’s because the lender is more concerned about the equity in your home, rather than how much income you’re bringing in on a monthly basis. As a cash strapped senior, you can access the equity you need in your home without having to sell it. It’s a win-win situation.
If cash flow is a concern of yours, another area where reverse mortgages shine is that unlike home equity loans, with a reverse mortgage in most cases you don’t have to make any payments on it until you sell your home or pass away, whichever occurs first.
With a home equity loan, you may have to make principal and interest payments. It’s also possible that the lender could call your home equity loan if you miss a payment or your spouse passes away.
Are Reverse Mortgages as Risky as Home Equity Loans?
In general, most experts recommend that consumers should avoid home equity loans whenever possible because they are too risky – especially if the loan is being used to pay off some other type of debt, such as your credit cards. You’d think borrowing from your equity to pay off cards would establish good credit. However, if you take out a home equity loan to pay off excess credit card debt, you are using your home as collateral.
As much as a credit card company or a collector may threaten that they can take your home to pay your bill, your assets can’t be liquidated for this kind of payoff without a bankruptcy judgment.
On the other hand, if you secure a loan using your home as collateral, then the lender can take your home if you fail to pay the debt back. If you get behind on your regular payments or face trouble, such as unemployment, you can lose your home. The last thing you want to deal with on top of financial distress is foreclosure.
By contrast, a qualifying for a reverse mortgage doesn’t have monthly payments, so there is nothing for you to fall behind in paying. The equity in your home is effectively like a savings account that you can borrow from.
It’s only after the last living owner passes away or moves out that the money comes due, so at no point will the lender take your home because you failed to pay your loan back. So whereas home equity loans are a risky proposition for almost any consumer to use, a reverse mortgage is a relatively safe option to use for seniors in the right financial circumstances.
The only payments you need to be concerned with are any property taxes and your homeowners insurance. You must keep up to date with these payments and maintain your home in good condition. As long as you do this and remain in your home, your reverse mortgage will not come due. With a home equity loan, you also have to pay homeowners insurance and taxes. In addition to the monthly payments, you must make payments on the loan.
But reverse mortgages aren’t without their risks. While it’s not possible to owe more money than the value of your home, that’s not to say reverse mortgages don’t have any risks.
You don’t have to make any monthly payments with reverse mortgages. Because that interest is compounding at a faster rate. Eventually there will come a time when you need to pay back your reverse mortgage, usually from the proceeds of the sale of your home. You may have little to no equity left if you’re forced to sell and move to a long-term care facility. This holds true if home values fall just when you’re looking to do that.
Life is always changing. As such plans can change. If you end up having to repay your reverse mortgage sooner than five years you may face a penalty. You’ll want to ask a lender for further details on that before signing up for a reverse mortgage.
Let’s look at the pros and cons of reverse mortgages in the next section to help you decide whether a reverse mortgage is right for you.
Pros of Reverse Mortgages
- You don’t need to make any regular payments on your reverse mortgage. This makes them ideal for seniors on fixed income whose cash flow may be tight.
- You have the freedom to use the reverse mortgage funds as you see fit. You can use them towards home renovations, living expenses, healthcare expenses and paying off other debt.
- Many seniors are “house rich, cash poor.” Reverse mortgages let you turn some of the equity into cash without needing to sell it. You can stay in your home and access the equity you need.
- Unlike other forms of income, such as CPP, OAS, RRIF withdrawals, workplace pension plans and investment income, you won’t have to pay any income tax on the money you borrow from your home as a reverse mortgage. This means you keep more of your hard-earned money in your pockets where it belongs.
- Money that you borrow by way of a reverse mortgage does not affect your eligibility for means-tested government benefits, such as OAS and GIS.
- Maintain ownership of your home. You don’t have to rent and deal with the uncertainties that come with that.
- You can choose when you receive the reverse mortgage money and how much you receive.
- If both your spouse and you own the home, the reverse mortgage won’t have to have paid back until the last one of you passes away or you sell the home.
Cons of Reverse Mortgages
- Although the interest rates on reverse mortgages have come down a lot in recent years due to the low interest rate environment, rates on reverse mortgages are still higher than most other mortgage products available. You’re typically looking at an interest rate that’s between 1.50 percent and 2 percent higher than a home equity loan. That’s because the reverse mortgage lender may have to wait years to receive any repayment at all.
- The equity you’ve worked so hard to build up over the years may dwindle as the interest on your reverse mortgage adds up over the years.
- Your estate will be responsible for repaying your reverse mortgage loan and the interest within a specified time period when you pass away. If you want to leave something to your estate, this could leave your family with next to nothing once the reverse mortgage lender is paid off.
- A reverse mortgage may prolong the time it takes to settle your estate.
- The fees with a reverse mortgage may often be more than a traditional mortgage and other similar lending products.
- If you have any lines of credit secured against your home, you may be forced to close them. That’s because the reverse mortgage lender will want to be in first position should anything happen to your home.
- It is possible to default on your reverse mortgage. For example, if you let your home fall into disrepair, the reverse mortgage lender could call the loan.
Reverse Mortgage Questions to Ask a Lender
Are you considering signing up for a reverse mortgage? All reverse mortgage are not created equal. Here are some questions to ask about reverse mortgages before signing up.
- Can you provide me with a list of the fees I would be responsible for with a reverse mortgage? Some of the common fees include appraisal fees, and a set up fee. There may be a prepayment penalty if you repay the reverse mortgage early. In addition, legal costs for closing the reverse mortgage and independent legal counsel.
- Once my reverse mortgage is set up, how do I access the funds? Are there any fees for accessing the funds?
- What’s the interest rate I’ll have to pay on any money I borrow by way of the reverse mortgage?
- What penalties are there (if any) if a sell my home within a certain timeframe?
- How long will my estate or I have to pay off the reverse mortgage if I move or pass away? For example, there may be a different repayment period if you have to move to a long-term care facility versus if you pass away.
- What occurs if it takes your estate longer than the allotted time to repay my reverse mortgage when I pass away?
- What happens if the balance owed on the reverse mortgage is higher than my home’s value when it’s time to repay the reverse mortgage? Will my estate or I have to make up the shortfall?
What are some Alternatives to Reverse Mortgages?
Before deciding on a reverse mortgage lender, it’s a good idea to shop around. It’s helpful to use an independent mortgage broker. A mortgage broker can help you decide which reverse mortgage lender is right for you. If a reverse mortgage even makes sense for you in the first place.
You’ll also want to consider alternatives to reverse mortgages. Those include taking out another type of loan, such as a line of credit or personal loan, selling your home, downsizing to a smaller home, selling and renting and moving to a long-term care facility.
It also helps to get a second opinion. Your family is a good place to start. Likewise, you can get an unbiased opinion from a financial planner.
Make sure you fully understand how a reverse mortgage works before signing up.