Focus on Finance: Home equity versus reverse mortgage

Question: I’m retired and have a small first mortgage on my home. To access my home’s equity, is it better to get a home equity loan or a reverse mortgage?

Answer: As with any financial decision, your specific situation and goals should determine the best course of action for you.

Generally speaking, you can convert your home’s equity into cash with either a reverse mortgage or home equity loan because both are based on the home’s market value minus any liens or indebtedness secured by the property. While similar in that respect, these loans work very differently.

First, typical home equity loans allow you to borrow a lump sum or set up a line of credit, usually not to exceed the value of the home’s equity. Either of these options will require credit scores and sufficient regular income to qualify for the loan. With a lump sum option, there will be regular monthly installment payments over the term of the loan and based on the interest rate charged.

A home equity line of credit, or HELOC, initially gives the borrower access to a set maximum limit of money, again based on the home’s equity. The difference is repayment requirements are triggered when the borrower draws money from the line of credit. The monthly repayment amount depends on the outstanding balance and the interest rate charged.

HELOCs normally have a limited “draw period” or number of years the line of credit is active. After that, the borrower can no longer draw funds, but still is responsible for repayment of any outstanding balance and interest. Again, there usually is an additional term after the draw period to make repayments.

One last point to remember about home equity or HELOC loans: The interest paid is no longer deductible on your federal income tax returns.

Next, if you are at least 62 years old and own your home, you might want to investigate a reverse mortgage to see if it is a fit for you. According to AARP, a reverse mortgage is a loan against your home you don’t have to pay back for as long as you live there. Also, instead of a lump sum or a line of credit, a reverse mortgage provides monthly payments to the borrower.

Reverse mortgages have been around since the late 1980s in the U.S. but saw their most rapid increase from 18,000 in 2003 to more than 107,000 in 2007, according to U.S. Depart­ment of Housing and Urban Development figures.

For some seniors, the opportunity to convert their home equity into ready, tax-free cash without selling their homes and no repayment required until they die or sell the home, sounds appealing — particularly if they are “house-rich, but cash-poor.” In other words, seniors who own their homes outright (or have small first mortgages) but are living on a fixed monthly income.

The monthly payment amount will depend on the homeowner(s)’ age, appraised value of the home and other terms — each reverse mortgage provider has specific requirements and limitations.

But reverse mortgages are not for everybody and can be relatively expensive compared to other home equity loan options. You’ll want to carefully weigh the benefits and downsides of all your home equity options as well as your specific financial needs before deciding. Also, consulting a professional financial adviser usually is a good idea.

Whether you want to prepare for unexpected expenses or just supplement your retirement income, tapping the equity in your home certainly is one option to consider.

Michael Bateman is a retiree who previously worked in marketing and corporate communications.