Both reverse mortgages and home equity lines of credit allow homeowners to tap into the equity of their homes in exchange for cash. However, these two loans work in very different ways, with different end results for the borrower.

Home Equity Loans and Lines of Credit

These types of loans allow homeowners to borrow money using their home as collateral, and can be taken out even if a home has already been mortgaged. With a home equity loan, the total amount that the homeowner borrows is advanced up front when the loan is taken out. The home equity line of credit, on the other hand, works in a fashion that is very similar to a credit card in that you have a maximum amount you can borrow, and have the option of choosing when you want to borrow the money.

As previously mentioned, both types of loans allow the homeowner to either exchange the equity in their home for cash. Most lenders will lend up to 75% of the homes appraised value, less the outstanding balance owed on the mortgage. For example, if your home is appraised at $250,000 and you owe $100,000 on your existing mortgage, you may be able to borrow $250,000 x 75% – $100,000, for a total of $87,000.

The way in which reverse mortgages and home equity lines of credit differ is in how interest is charged. The home equity loan interest rate is typically fixed and amortized for up to fifteen years. Alternatively, instead of a balloon payment the borrower can opt for a reduced amortization period that is due when the amortization period is over. The home equity line of credit interest rate is usually variable, rather than fixed, and has a typical draw period (the time in which the borrower can access funds) of between five and 25 years. When the draw period is over, the principal is paid either as a balloon payment or in accordance to an amortization schedule.

The main advantage of choosing a line of credit over an equity loan is that with the former, you only pay interest on the money you draw, rather than the entire sum that you can potentially borrow. However, with both types of loan, the borrower’s home is the collateral, meaning that defaulting on repayments could potentially lead to foreclosure.

Given that the loan is tied to their most valuable asset, a large number of borrowers choose to use home equity funds only for major expenses, such as college costs or medical expenses. Home equity lines of credit and home equity loans are also popular choices among homeowners looking to increase the value of their homes through remodeling.

Reverse Mortgages

A reverse mortgage also provides the borrower with the ability to tap into the equity of their home. The two biggest differences between reverse mortgages and home equity lines of credit are that there are no monthly repayments to make, and the loan does not have to be paid back until the borrower either passes away or sells their home. If either of these situations occurs, the house is sold and the proceeds are used to pay off the balance of the reverse mortgage.

Reverse mortgages are made available only to homeowners aged 62 years or older. There are virtually no other requirements and neither your credit rating nor your income affects your eligibility. For seniors, this is usually the easiest way of exchanging home equity for cash.

It is even possible for homeowners to obtain a reverse mortgage if they still owe a small amount of money on their conventional mortgage. However, should this situation occur, you are still required to pay the balance of your conventional mortgage.

Another advantage of the reverse mortgage is that you can choose how to have the money you borrow paid to you. You can choose to receive it as an up-front lump sum, as regular monthly payments, or as a credit card-style account where you draw money as you need it. In some cases you can even choose a combination of these options.

There are also some negative aspects associated with reverse mortgages that potential borrowers should be aware of.  First, reverse mortgages have high upfront costs. These upfront costs are typically between five and six percent of the underlying homes value. This is one of the reasons why the loans are so profitable to the lenders. Reverse mortgages are also subject to interest and finance charges, including loan origination fees. This means that the borrower either has to come up with cash to pay for these charges, or roll the finance costs into the mortgage. With the latter option, however, you end up paying interest on the finance charges from the beginning of the loan.

Another issue that can potentially turn into a problem is that associated property taxes and insurance are still payable by the owner of the property. And while you can’t lose your home, some reverse mortgages have conditions that stipulate that if the borrower defaults on their property taxes or insurance, the balance of the loan is due immediately.