Reverse Mortgage, Home Equity Loan or Refinance? The Pros and Cons of Each

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Home equity is a valuable financial resource. By definition, it’s the difference between your home’s value and how much you owe on your mortgage. For example, if your home is worth $500,000 and you have a $200,000 mortgage, you have $300,000 in equity. 

If you qualify, you can borrow against that equity to access cash. Three common avenues for doing so are reverse mortgages, home equity loans and cash-out refinancing.

What Is a Reverse Mortgage?

A reverse mortgage is a loan for older homeowners who have significant amounts of equity. You may be eligible if you’re 62 or older.

If you qualify, you can borrow up to a set limit based on your age, the value of your home and the loan’s interest rate. Depending on the loan agreement, you can collect those funds as a lump sum, in monthly payments or through a combination of the two.

The loan doesn’t have to be repaid until you sell your home or die. However, interest accumulates every month. You’re also still responsible for any taxes and insurance on your property.

Advantages of Reverse Mortgages

• Flexible payouts: Because reverse mortgages can be paid out immediately or over time, they’re adaptable to the individual’s needs.
• Delayed repayments: If you have a limited income, a reverse mortgage can help you meet your expenses without adding to your monthly costs.

Disadvantages of Reverse Mortgages

• Maintenance standards: Your home must be in good condition and meet specific requirements. If it doesn’t, you may need to pay for repairs before you can borrow. 
• Balance limits: You must have a small mortgage balance or none at all.
• Family impact: If you have a spouse whose name isn’t on the loan, the borrowing rules may limit how long they can stay in the home after you move out or die. Also, your estate is responsible for the debt if you don’t pay the balance before you die. 
• Growing debt: Interest will accumulate for every month in which you have an active loan.

What Is a Home Equity Loan?

A home equity loan lets you borrow against a set amount of your equity. Unlike a reverse mortgage, home equity lending has no age limit.

With a standard home equity loan, you receive the borrowed amount as a lump sum and pay it back with equal monthly payments, including interest. Most home equity loans have fixed interest rates, meaning they don’t change based on the prevailing market rates.

Another option is a home equity line of credit, which permits you to borrow up to a set limit. You can access the money at any time during the borrowing period, also called the draw period. Many HELOC agreements make you pay interest only until the draw period closes and the repayment period begins.

HELOCs tend to have variable interest rates, meaning your rate could increase if interest rates rise across the market.

Advantages of Home Equity Loans and HELOCs

• Lower-cost borrowing: Home equity loans and HELOCs typically have lower interest rates than credit cards.
• More options: You can choose a lump sum with a fixed rate or revolving credit with a variable rate. 

Disadvantages of Home Equity Loans and HELOCs

• Risk to your home: Your property secures both types of loans. If you violate the payment terms, the bank can foreclose on you.
• Potential balloon payments: Some lenders offer interest-only loans, which leave you with a large lump sum to repay.

What Is Refinancing?

Mortgage refinancing entails opening a new loan that replaces your original mortgage. The money from the new loan goes toward repaying the original, and your subsequent payments go to the new lender. There are two ways you can refinance:

• Rate and term refinancing: You borrow the same amount you owed on your previous loan, but the terms differ. You might have a lower interest rate or a different repayment duration, such as a 15-year mortgage instead of a 30-year mortgage. 
• Cash-out refinancing: You take out a mortgage with a higher principal amount than your current loan, collecting the remainder in cash. Depending on your qualifications, you can borrow up to 80% of your mortgage’s current value. 

You don’t have to secure a lower interest rate to refinance, but it’s the best way to minimize your borrowing costs. Taking out a new loan typically involves fees, so you’d generally want to shell out that money only if it puts you in a better place.

Advantages of Refinancing

There are a few ways refinancing can improve your financial situation. You might:

• Lower your repayment total: You may be able to reduce the amount you pay back by lowering your interest rate or shortening your loan term. If you pay the loan off sooner, the interest has less time to grow.
• Reduce your monthly payments: A lower interest rate often means reduced monthly payments. One caveat — if you shorten your loan term, your payments may be higher because you’ll be paying back the same principal balance over fewer installments.
• Switch your rate type: If you have a variable-rate mortgage and are worried about interest rates increasing, you can switch to a fixed rate when you refinance. You also have the option of switching from fixed to variable.

Disadvantages of Refinancing

• Additional borrowing costs: According to Freddie Mac, refinancing usually costs an extra 3% to 6% of your new loan amount in appraisal, origination and underwriting fees, among others.
• More debt: Cash-out refinancing leaves you with a higher mortgage balance. 
• Risk to your home: As with any mortgage product, your home secures the loan. A default would put it at risk.

Whichever equity lending option you choose, work with a reputable lender and read all of your agreements in detail. 

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