Reverse Mortgage vs Cash-out Refinance
If you have equity in your home, you have options when you run into a cash crunch. That’s especially true once you reach the age of 62.
If you find yourself entering your senior years with some financial needs, you might consider tapping the equity you’ve built up in your home to provide you with money to pay bills, make home improvements or to improve your monthly cash flow.
There are several ways that senior adults can do this, but two are particularly common: Reverse mortgages and cash-out refinances.
In this article, we’ll lay out the differences in the two equity lending products and what situations might call for one over the other.
What is a reverse mortgage?
A reverse mortgage allows you to borrow against the equity in your home, but unlike a traditional loan, it does not require a mortgage payment. The interest on the reverse mortgage accumulates over time and the full balance is paid when you move out, sell your home or pass away.
To qualify for a reverse mortgage, you must be 62 or older and the home must be your primary residence. You must own the home without a mortgage or have a substantial amount of equity built up. Equity refers to the difference between the value of the home and any outstanding mortgages.
You must also provide documentation that you can continue to afford to pay taxes, homeowner insurance and utilities for your home. Lenders look at how much money homeowners will have left over each month after all their bills are paid, taking into account the proceeds of the reverse mortgage and any income from Social Security, a pension or from retirement savings.
Although there is no minimum credit score requirement, the lender will review your credit report and check to be certain there are no liens on your home, particularly for property taxes.
The most common type of reverse mortgage is insured by the Federal Housing Authority and known as Home Equity Conversion Mortgages, or HECM loans. These loans have an additional layer of consumer protection: Reverse mortgage borrowers are required to receive counseling from a HUD-approved counselor.
“The FHA is very sensitive to the well-being of reverse mortgage borrowers,” said Eric Rittmeyer, president of Fidelis Mortgage in Baltimore.
The limits for an FHA-insured HECM mortgage is $726,525 in 2019. But the amount a specific person can borrow depends on the age of the homeowner, the value of the home, the amount of equity in the home and current interest rates for reverse mortgages.
If you pass away while living in the home, your heirs have six months to pay off the reverse mortgage by selling the property, using their own savings or a cash inheritance or by using conventional financing if they want to keep the house, Rittmeyer said. They can request two extensions of three months each, which gives them the possibility of up to one year to repay the loan or sell the house.
Pros and cons of a reverse mortgage
The main benefit of a reverse mortgage is the ability to eliminate the monthly expense of a mortgage and concern about losing a home to foreclosure.
Then, depending on how much equity you had in the home, you can receive money as a lump sum, monthly payments, a line of credit or a combination of these options. That income is tax-free and can be used for anything you want, such as to pay medical expenses, make home improvements or pay for daily needs. The line of credit can be in place as an emergency fund for future needs.
A disadvantage, however, is the cost of a reverse mortgage. Fees and closing costs can add up to about 6% of the home value, Rittmeyer said.
“When the parents use the equity in their home now, there will be less of it for their kids to inherit,” Rittmeyer said.
What is a cash-out refinance?
A cash-out refinance is also a form of an equity loan, but it works a lot differently from a reverse mortgage. A cash-out refinance replaces your existing loan with a new mortgage for a larger amount than you currently owe. The new loan will repay your current mortgage and you will receive the remaining cash in a lump sum. After that, you pay your new mortgage each month like normal.
Cash-out refinancing is available on a primary residence, second home or investment home. The requirements for a cash-out refinance are similar to a standard mortgage, but since these loans are considered a little riskier, you may need a higher credit score of 650 or above, said Trish Geddes, vice president of operations for Consumer Credit Counseling Services of Maryland and Delaware.
How much you can borrow and your interest rate will depend on your credit score and your home value. If you own a home valued at $200,000 and owe $100,000 on your mortgage, you might qualify for a cash-out refinance of $160,000 to pay off the first mortgage and keep $60,000 in cash.
The more equity you wish to borrow, the higher your credit score will need to be. You’ll also likely need a lower debt-to-income ratio, which compares your monthly gross income and the minimum payments on all your debts including your housing payment.
Pros and cons of a cash-out refinance
A cash-out refinance allows you to access the equity in your home, while potentially also lowering your interest rate or improving your loan terms. You might shorten the length of the loan, switch from an adjustable rate mortgage to a fixed-rate, or move from an FHA loan that requires mortgage insurance to a conventional loan without the requirement.
Another advantage of cash-out refinancing is that the interest paid on a mortgage can be tax-deductible, unlike the interest paid on other debt, Geddes said.
You can use the cash from your refinance for any purpose, but this can be a double-edged sword.
“As with any financial decision, it’s wise to go in with your eyes wide open,” Geddes said. “Taking out money from your home for a vacation isn’t the wisest consumer choice, especially compared to spending the money on a major repair that will improve the safety and value of your home.”
Some borrowers choose a cash-out refinance to consolidate their debt, but Geddes said this could be problematic.
“If you aren’t changing your behavior, you could just be obligating yourself to a longer loan term with your refinance. Your payment may have gone up because you have a larger balance and the credit cards are now available again for you to use,” Geddes said. “On the other hand, this could be a good move if your credit card debt was accumulated because of a specific situation such as a job loss or medical expenses.”
Reverse mortgage vs. cash-out refinance
|Comparing Reverse Mortgages and Cash-Out Refinances|
|Reverse Mortgage||Cash-Out Refinance|
|Who qualifies?||Homeowners age 62 or older; Primary residence only||Owners of a primary residence, second home or investment property|
|Monthly payment||None||Principal and interest; taxes and insurance|
|Interest rates||Slightly higher than traditional mortgage rates||Typically lower than a reverse mortgage or home equity loan|
|Credit score requirement||No minimum, but borrowers must show creditworthiness||640 or higher, depending on lender|
|Fees and closing costs||Approximately 6% of your home value||Approximately 3% to 6% of your loan amount|
When a reverse mortgage might work better
A reverse mortgage can be a good option for borrowers in certain circumstances, as long as you understand the risks. For example, a reverse mortgage can be helpful if:
- You plan to stay in your home.
- You are retired and need income.
- You are older than 62.
- You want to eliminate your mortgage payment to ease your cash flow.
- Your home needs repairs or improvements so you can age-in-place.
- You don’t qualify for other forms of credit.
When a cash-out refinance might work better
A cash-out refinance can be a good way to access the equity in your home for some homeowners. For example, a cash-out refinance could be the better choice if:
- You are working and earning income.
- You are younger than 62.
- You want to pass on the home to your heirs with the greatest possible value.
- You plan to sell your home in the future and want the maximum profit from the sale.
- You need to finance home improvements and want the ability to deduct the interest payments on your taxes.
- You want to pay a lower interest rate on your financing.
Key considerations when deciding between a reverse mortgage and cash-out refinance
When comparing a reverse mortgage vs. cash-out refinancing, it’s important to answer some of the following questions:
- Are you trying to get cash from your residence, a vacation home or an investment property?
- What do you want to use the money for?
- How much equity do you have in your home?
- How long do you plan to stay in your home?
- If you plan to stay in your home forever, do you want family members to inherit it for their use or to sell it?
- Do you have the income to make mortgage payments?
- Will you be able to continue to afford your property taxes and insurance even if you eliminate your mortgage payment?
- Can you qualify for a refinance?
- Will you pay cash for your closing costs or wrap them into the loan balance? If you include them in your financing, that will reduce the amount you can borrow.
The bottom line
To determine whether a reverse mortgage or a cash-out refinance is the best way to access your home equity, it’s wise to consult a housing counselor who can review your budget and loan options. If you’re younger than 62, you’ll have to choose a cash-out refinance or wait until you’re older. If you’re older than 62, you can compare reverse mortgage and cash-out refinance details such as fees and long-term consequences to make the right choice for your individual circumstances.