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For older Americans interested in remaining in their homes as they age, a home equity Loan (HEL) or line of credit (HELOC) may provide a useful way of financing. Additionally, older people who own their homes can use that equity through a reverse Mortgage called a Home Equity Conversion Mortgage (HECM). Understanding the differences between these two financing options can sometimes be difficult. This article looks at how a home equity loan differs from a reverse mortgage, and can help people decide if one of these options is right for them.

One of the main similarities between an HEL/HELOC and an HECM is that they both require equity to be built in a borrower’s home. Neither of these loans are options for homeowners who are underwater (i.e., owing more on your mortgage(s) than the home is currently worth). As well, the actual costs of both types of loans are more than just the amount borrowed; the homeowner must pay for ‘points’, closing costs, appraisal fees, inspections, and anything else they might be expected to incur when getting a home mortgage.

However, there are also many key differences between HELs/HELOCs and HECMs, including who is eligible, loan amounts, and repayment options.

How is the loan administered?

Home equity loan/line of credit: When a borrower takes out an HEL or HELOC they are establishing a new mortgage. A lender calculates the maximum loan amount a borrower can receive, based on credit worthiness, income, and the maximum amount of equity that can be tapped from the home. The lender sets the terms, establishing a fixed interest rate and repayment term.

Home Equity Conversion Mortgage (reverse mortgage): With an HECM the borrower takes out a mortgage that pays the borrower on the basis of the home’s value, up to the maximum equity limit. Since the loan does not require repayment until the borrower no longer lives in the home, the lender does not consider credit worthiness or income. As a result, the total value of the home and the equity amount determines the loan amount. For an HECM, the Federal Housing Administration sets the maximum amount a homeowner can borrow, but this can change to reflect fluctuations in the housing market. Homeowners with high-value residences, or those who have built substantial equity can still receive an HECM, however the amount they’ll receive is restrained by these maximum settings.

Who can apply?

Home equity loan/line of credit: Homeowners seeking an HEL or HELOC have no age restrictions, only income and credit requirements. These borrowers also do not need to own their home outright.

Home Equity Conversion Mortgage (reverse mortgage): Borrowers seeking an HECM must be a minimum of 62 years old (to determine eligibility and loan amounts, the youngest homeowner’s age is used). There are no income or credit requirements because these loans are based on the value of the home and the amount of equity, not on the borrower’s ability to repay in installments. Additionally, these borrowers need to use their home as their primary residence. It’s a good idea for reverse mortgage borrowers to own their homes outright, because if not, they’ll need to pay off any previous mortgages, liens, or other home-secured debt through the HECM transaction itself.

Home equity loan/line of credit: With an HEL or HELOC, the loan size is determined using a series of calculations, including how much the borrower can afford to repay within a set period of time. In other words, the loan amount is determined by the amount of equity in a home, plus the homeowner’s income compared to debt, as well as their ability to make regular payments as soon as the loan reaches maturity.

Home Equity Conversion Mortgage (reverse mortgage): With an HECM, there is no set time to begin making repayments, so the loan amount is not limited to how much the homeowner can repay. Instead, the loan amount is limited to the value of the home, how much equity has accumulated, and the age of the borrower(s) at loan inception.

Who owns your home?

Home equity loan/line of credit: When a borrower takes on an HEL or HELOC the lender places a lien on the home. This means that if the borrower defaults on the home equity loan, the bank may initiate proceedings that allow them to take ownership of the home and sell it to recoup the amount they’re owed from the borrower. Even if the homeowner is current on their first mortgage, the home equity lender can still begin foreclosure proceedings if the borrower is behind on those payments.

Home Equity Conversion Mortgage (reverse mortgage): A reverse mortgage is different. With a reverse mortgage, the borrower continues to own the home because they retain the title. Instead of making payments on a second mortgage, the borrower gets paid by this second mortgage. In addition, the borrower must continue to pay property tax, Insurance, etc. And just like any mortgage, borrowers receive a monthly statement which outlines all interest charges and balance information, but will not include a mortgage coupon, because no payment is required.

The difference between an HEL/HELOC and an HECM is one large reason some borrowers who have taken out a home-secured loan seek out a reverse mortgage. They use the loan from the HECM to repay the HEL/HELOC, and retain title of the home, so they’re not at risk of losing it to foreclosure.

How is the loan repaid?

Home equity loan/line of credit: An HEL is a loan paid in one large amount, and after it reaches maturity, must be repaid in monthly installments. In terms of an HELOC, since it’s a line of credit and the amount used is determined by the borrower, the borrower pays monthly installments that typically consist of interest, with the principal to be paid as borrowed.

Home Equity Conversion Mortgage (reverse mortgage): A reverse mortgage is unique because the borrower does not need to make payments on the principle balance or the interest due. In fact, not repayment is due until the last surviving borrower dies or is no longer able to make the home their primary residence. Whether the borrower passes away, or has to move someplace else for longterm care, the borrower’s family member(s) have ample time up to 12 months to sell the home or refinance the loan to in order to pay back the balance due. If the home is not sold, or the remaining family members cannot repay the loan in its entirety, the bank may foreclose in order to recoup the balance of the loan. If the home is sold for more than the HECM amount, the remainder will be returned to the family. If the home is sold for less than what is owed, the Mortgage Insurance fund covers the short-fall, so the family member of the borrower is not responsible for this.

Anyone considering a reverse mortgage like an HECM should discuss the details with trusted family members, and seek a lender in their area. Reverse mortgage counseling is required before initiation of the process, and can help potential borrowers understand the specifics of these loans, and help determine whether they are a good fit.

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by CreditQ Staff

Published 06/11/2012 15:49