How to Choose Between a Reverse Mortgage and a Home Equity Loan

A reverse mortgage has one overwhelming advantage over other forms of borrowing: there are no monthly payments to the lender -- ever. For many, that's all they want to know. However, these loans come with some very real dangers, not least the risk of foreclosure. Of course, they can work very well for some people, but everyone who signs up for one should first make sure he or she fully understands the deal -- and that every other option has been properly explored and considered. In particular, home equity loans can sometimes be safer, cheaper, and better ways to access the money tied up in a home. But who should choose which?

When a Reverse Mortgage Is the Right Choice

A recent report from federal regulator, the Consumer Financial Protection Bureau, revealed widespread misconceptions about reverse mortgages -- most of which are backed by the Federal Housing Administration (FHA), which calls them "home equity conversion mortgages" or HECMs. Extraordinarily, many of those misimpressions arise from advertisements for these loans. When shown such ads, some people failed to understand they were loans at all, some assumed "tax-free" meant property taxes would no longer be payable on the home, while others believed the products offered life-long financial security. To be clear:

  1. While no monthly payments are required as long as one or more of the borrowers named on the mortgage documents remain resident in the home (and a recent judgment means in some circumstances unnamed surviving spouses may enjoy new protections), the amount originally borrowed, plus ongoing costs such as mortgage insurance premiums (MIPs), and the interest compounding away in the background, are still owed. They all fall due as a single lump sum when the home is sold, usually when the borrower(s) dies or moves, possibly into a care home. The good news is that no matter how high that lump sum grows, the lender can't come after the borrower or the borrower's estate for any amount over the sale price of the home.
  2. Borrowers continue to be liable for paying property taxes, home insurance premiums and any homeowner association fees, and for maintaining the home in good condition. If they fail to meet those obligations, they could ultimately face foreclosure.

The first of those bullet points makes reverse mortgages especially attractive to those who require a long-term loan with zero monthly payments. It also makes them work particularly well for those who aren't bothered by the sizes of their estates, possibly because they have no children or have children who aren't relying on an inheritance.

The second bullet point is a reminder that one of these loans may be "free" until the final lump sum repayment falls due, but it's no guarantee of financial security. It's generally a good idea to take as high a proportion of the borrowing as possible in the form of equal monthly payments (similar to income from an annuity) and as lines of credit, and to minimize the value of initial cash withdrawals. Holding back for later years some of the equity released should provide higher levels of security in the future. There are exceptions to this rule: for example, when paying down existing high-interest debt that's eating into disposable income that's already tight.

One final advantage concerns credit requirements. Although borrowers' credit histories are verified during the HECM application process, it's often unnecessary to have the sort of impressive credit score that's typically required for home equity loans. That's particularly useful for those -- usually older -- people who haven't borrowed much recently, and who thus have thin or nonexistent credit files and low scores.

When a Home Equity Loan Is Better

A home equity loan is usually preferable when a short-term injection of cash is required, and the borrower can comfortably pay back the loan. That's mostly because reverse mortgages tend to come with higher closing costs, fees, MIPs and interest rates, and are simply uneconomic for filling brief holes in cash flow.

Owing to the high set-up costs of HECMs, they are almost always a very bad idea for those who are likely to move from the home soon after putting the loan in place. If that's on the cards, a loan rather than mortgage is almost certain to be the less expensive choice.

Of course, these loans are also open to homeowners of any age, whereas HECMs are available only to those age 62 years and over. Some financial advisers recommend waiting for as long as possible before applying for an HECM because older borrowers may receive a better deal (lenders base some of their calculations on each borrower's life expectancy) and the equity released has to last a shorter time. However, if interest rates rise over the coming months and years, that calculation could change.

Because reverse mortgages are highly complicated, it's always a good idea to consult a counselor before committing to one. Indeed, the FHA makes this mandatory for the HECMs it backs. This provides an opportunity to fully explore all options with an independent expert at no or low cost. And it gives people a chance to discuss the form of borrowing that best meets their individual needs.

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