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October 25, 2022

Which Is the Better Option for You – Home Equity Loan or Reverse Mortgage?

Right now, the average mortgage holder has $185,000 in equity, which is a record-high rate. Many homeowners are considering using those funds to cover their current financial needs. 

But is a home equity loan the right choice to access that equity, or should you consider a reverse mortgage instead? 

Today, we're covering the differences and advantages of both as we compare a home equity loan vs. a reverse mortgage. Find out which option is best for you and how to proceed. 

What Is a Home Equity Loan? 

A home equity loan is also known as a second mortgage, and it allows you to take your equity and turn it into cash. Borrowers make payments every month for a set number of years. Usually, the time period is anywhere from 5-30 years. 

Banks, online lenders, and credit unions may offer a home equity loan to eligible homeowners. Lenders will examine a homeowner's credit health and current financial situation to set a loan amount. As such, you'll want to meet certain eligibility requirements, such as having a low debt-to-income ratio and a credit score of Fair or higher. 

We'll cover the exact requirements later on. 

What Is a Reverse Mortgage? 

Seniors often use a reverse mortgage to tap into their equity. To apply for a reverse mortgage, a homeowner must be 62 years of age or older. 

The big difference between home equity loans and reverse mortgages is that homeowners no longer have to make monthly mortgage payments.

The lender will obtain possession of the house upon the homeowner's passing unless there is a surviving spouse. Surviving heirs must pay any remaining balance or at least 95% of the property's appraised value. 

A Home Equity Loan vs. Reverse Mortgage: The Differences

Although both a home equity loan and a reverse mortgage are ways to access your equity, there are quite a few differences. Eligibility requirements vary between the two, as do payments, available options, etc. 

Here's a more detailed breakdown, so you can learn more about which option is right for your situation. 

Eligibility Requirements

Before extending an offer for a home equity loan, lenders will assess your credit score, income, debt, assets, credit history, and financial health. In most cases, you'll need a credit score of 620 or better and a debt-to-income ratio of around 43% or lower. Additionally, homeowners must have around 15-20% of equity in their homes. 

Homeowners can borrow up to 85% of the home's value. However, the value received will depend on  the remaining amount still owed on the mortgage. The exact amount you get is up to the lender, as they'll assess your financial situation. 

Reverse mortgages are reserved for seniors. Adults aged 62 years and older may qualify. Lenders will consider an applicant's age, credit history, and income to reach a decision. 

Loan-to-Value Ratio

loan-to-value (LTV) ratio compares the amount borrowed to the market value of the house. High LTV ratios are known as higher-risk loans.

A loan with a high LTV ratio may require a homeowner to buy mortgage insurance. Mortgage insurance protects the lender in the event the borrower defaults on their payments. 

The formula used to calculate the LTV is:

LTV = Mortgage Amount / Appraised Property Value. 

Combined loan-to-value (CLTV) amounts determine how much someone can get when they apply for a home equity loan. 

CLTV = Mortgage Balance + Home Equity Loan Balance / Appraised Property Value. 

In a reverse mortgage, the principal limit refers to the loan-to-value limit. It's determined by considering the age of the youngest borrower, the value of the house, and the interest rate. 

Home Equity Conversion Mortgages (HECM) are the most common type of reverse mortgage. These are offered by FHA-approved lenders and have a maximum limit of $970,800. If a homeowner needs more, they may go to a private lender. 

FHA-approved HECMs do require applicants to get mortgage insurance. In this case, mortgage insurance protects the borrower if the bank defaults on their payments. However, a reverse mortgage that isn't FHA-approved may not require insurance. 

Making Payments

Homeowners that get a home equity loan make monthly payments that include both principal and interest. Since home equity loans act as second mortgages, they have a fixed interest rate. However, it's important to note that if you miss payments, lenders can foreclose on your house. 

For reverse mortgages, you won't make monthly mortgage payments. Instead, a lender will send monthly payments to you all at once or spread out.

There are fixed-rate reverse mortgages and adjustable reverse mortgages. For fixed-rate reversed mortgages, homeowners get the amount in a lump sum. 

Payment options include: 

  • Line of credit
  • Tenure
  • Modified tenure
  • Term payments

The amount of equity that can be turned into cash also varies depending on the homeowner's age. In most cases, older homeowners can get more. 

Missing homeowner's insurance payments or defaulting on property taxes can result in you losing your home. 

The Best Candidate

Home equity loans are best for borrowers that have a lot of equity and need the money for a specific purpose. It's best for borrowers to know how much they need in advance as they receive a lump sum. 

Older homeowners with a large amount of home equity or seniors that have paid off their mortgage might consider a reverse mortgage. They may receive payments in a lump sum, line of credit, or in regular payments. Often, a reverse mortgage is used to supplement retirement income. 

Which Is Right for You? 

You have options if you need to tap into your home's equity. When it comes to a home equity loan vs. a reverse mortgage, which is right for you? 

To sum it up, seniors aged 62 and older with a significant amount of home equity may consider a reverse mortgage. If you're younger and you need a lump sum, you might want to consider a home equity loan. 

Determining the right loan for your needs can be a complicated matter. Here at Southern Home Loans, we want to make it easier. Reach out to us to discuss your options or apply now. 

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