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Reverse Mortgage vs. HELOC vs. Personal Loan

| Money Rates Columnist.
min read

lady-nurse-talkIt's not uncommon for older homeowners to run into situations where they need extra funds to pay for a major expense.

Fortunately, for those who qualify, there are a number of financing options that can help.

Do your homework, shop around, and plan prudently, though. You may find that one of these types of loans is your best bet, or you could find a different solution using other financial avenues.

Compare today's personal loan interest rates

Why Older Homeowners Tap the Equity in Their Home

Typically, older homeowners have worked hard over the years to meet their responsibility of paying the mortgage punctually every month.

Paying down the principal and interest is how you accumulate equity in your property over time, which can add to your ability to respond to unforeseen financial events.

And that's a good thing because, the truth is, any adult can wind up needing extra cash from time to time -- regardless of age.

"You may want to pay for a child's or grandchild's educational expenses. Or maybe you want to buy a smaller home in a more affordable locale without selling your current home so that it can be left to your heirs," says Rajeh Saadeh, a real estate attorney.

Charles Gallagher, an attorney with Gallagher & Associates Law Firm, P.A., cites other reasons too -- including home repairs or renovation plans, an upcoming major medical event, or even a yearning to travel.

"But in today's economic climate, the most common reason is that older homeowners simply don't have enough saved up," notes Adem Selita, CEO of The Debt Relief Company.

The good news?

If you own your home free and clear or have garnered sufficient equity, it can be a lot easier to acquire a loan or line of credit.

What Types of Loans Let You Access Your Equity?

A reverse mortgage or home equity conversion mortgage (HECM), a home equity line of credit (HELOC), or even a personal loan are among the options homeowners have when they need to access the equity in their home.

Each option has its advantages and disadvantages. That's why it's important to compare loan products carefully, weigh the risks, and forecast your long-term goals and needs carefully.

Reverse mortgage

A reverse mortgage is one of the most common loan products that allow you to convert your home's accrued equity into cash - but there are specific requirements for this kind of loan.

Gallagher explains that a reverse mortgage is a loan available to homeowners age 62 and older who have paid off their traditional mortgages or have built up significant equity in their home. But the home must also be their primary residence, for example.

The lender makes mortgage payments to you either in the form of a lump sum, monthly/regular payments, or as a line of credit you can withdraw from when you want. The loan must be paid back in full, with interest, at the end of the loan term or when the property is sold.

Home equity conversion mortgage (HECM)

One popular type of reverse mortgage is the Federal Housing Administration's federally insured Home Equity Conversion Mortgage (HECM). These are often preferred to private reverse mortgages because they may have more favorable terms. But HECMs require that you pay mortgage insurance premiums, and the loan amount is fixed.

The pros of reverse mortgages are that you maintain ownership in your home, your obligation to repay the debt can't surpass the property's value (protecting your heirs), and the funds you receive aren't taxable.

Among the disadvantages, associated fees (including closing costs) can be expensive, you can be foreclosed upon, and the amount of equity you can tap can be smaller unless you choose an adjustable rate. In addition, you must use your home as collateral; if you can't repay the debt, you could lose your home.

"Also, the interest you pay will accumulate. And often, the interest plus principal can swallow all equity in your home. That can leave you or your heirs with nothing once the home is sold," explains Saadeh.

Home equity line of credit (HELOC)

With a HELOC, you tap into your home's equity when needed. You can withdraw funds up to a preapproved spending max over a set term (typically the first ten years). This spending limit is determined by your income and credit score.

On the plus side, "anyone with available equity in their homes is eligible, although different loan-to-value requirements apply," Selita notes.

A big plus is that, if you apply and are approved, you don't have to use a HELOC until you're ready.

Randall Yates, CEO of The Lenders Network, says a HELOC works just like a credit card.

"You don't start making payments until after you begin borrowing against your credit line," says Yates.

What's more, "you only have to pay the interest you owe during the draw period," says Selita. "And you can pay off the line in full or make minimum payments."

On the downside, HELOCs come with adjustable interest rates that can fluctuate, resulting in higher repayments than you might expect. And you have to use your home as collateral.

"But a HELOC is safer than a reverse mortgage. You generally have a first mortgage ahead of the HELOC in lien priority. So the risk of losing your home to a HELOC default is less than with a reverse mortgage," Gallagher says.

Personal loan

A personal loan is an unsecured loan that simply requires your signature instead of any collateral. Often, these loans are repaid over 24 to 60 months.

A good candidate for a personal loan is a homeowner who has little equity built up or who doesn't qualify for other financing options.

Benefits of a personal loan include less risk if you are unable to repay the loan due to economic hardship or another reason.

"Because the loan is not secured via collateral, like your home, it provides the most protection for homeowners in the event of default," says Gallagher.

It may also be easier to qualify for a personal loan than a HELOC or HECM/reverse mortgage.

But there are several reasons why this option is often the least recommended among these three choices.

"A personal loan usually has a higher interest rate and sometimes a steeper monthly payment relative to other options," Selita cautions.

Also, you could be penalized if you try to pay off the personal loan early. And you may be forced to pay an origination fee up to 6% of your borrowed amount.

What The Experts Recommend

So which option is best for you? That depends on many factors, the pros agree.

"Home equity lines of credit are the best choice, in my opinion," says Yates. "You're provided with a line of credit you can borrow from only when you need to. And you're only charged interest on the amount borrowed. Your equity will only decrease when you use the credit line. And HELOCs come with very low closing costs, and the interest paid can be a tax write-off."

However, if you're older and can't afford to take on more debt payments, "a reverse mortgage is something to consider," Yates says.

Saadeh agrees that a HELOC is likely preferred among these three selections.

"It comes with a lower interest rate and a higher maximum than a personal loan. And unlike a personal loan, it can be used as needed during the draw-down period," says Saadeh. "You have less risk of being duped by a predatory lender too. Many scammers are pushing shady personal loans."

Gallagher, on the other hand, likes the flexibility that a personal loan offers.

"Given that it affords the most protection for the borrower -- as no collateral is needed -- I would recommend an unsecured personal loan. If that's not feasible, I would then consider a HELOC, if you have a first mortgage in place," says Gallagher. "A reverse mortgage is fraught with the most risk and uncertainty."

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What are the Alternatives to Reverse Mortgages/HECMs, HELOCs and Personal Loans?

These aren't the only options from which you can choose, of course.

Instead, you could explore a home equity loan, cash-out refinance of your mortgage, or a credit card that offers a low/no interest introductory rate (assuming you can pay off your balance before higher rates kick in).

"An older homeowner should also consider selling their home to a buyer but preserving a life estate in the home. This means that your home would not necessarily be owned by you any longer. But you'd have the right to live in the property as long as you live," explains Saadeh. "This would provide you with cash to do with as you please while preserving your residence during your lifetime. And it ensures that your heirs don't have to deal with unloading a home saddled with debt."

But you might want to ponder financing with a direct lender without encumbering your home as collateral.

"For example, say you need extra money to install a whole new HVAC system. You may be better off to apply for financing directly with the HVAC vendor to avoid the risk of having your home held as collateral for the loan," suggests Gallagher.

Whatever financing route you explore, be sure to perform your due diligence.

"Carefully vet the party lending you money. Check for complaints against them. Determine if you have any rescission period under the written agreement to kill the deal after you've signed," advises Gallagher.

"And when in doubt, talk to an attorney. Many will discuss this kind of issue gratis on the phone and provide helpful feedback before you have to sign off on any terms."

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