Comparing home equity and reverse mortgage lines of credit. HELOC vs HECM Line of Credit 2016.
If you have equity in your home but not much cash, you can turn the former into the latter by taking out a Home Equity Line of Credit (HELOC).
And if you’re at least 62 years old and have a qualifying property, you may also have the option of a Home Equity Conversion Mortgage (HECM) line of credit, also known as a reverse mortgage line of credit.
So if you have the option of an HELOC or an HECM line of credit, which one should you choose?
What you have and what you want
Much of the decision will be based on how much equity you have in your home and how much you want/need in your line of credit.
One of the advantages of the HELOC is that you don’t need as much equity in your home to qualify as you do with a reverse mortgage. While it’s not required to own your home free and clear before applying for a reverse mortgage, any mortgage balance you have should be a small percentage of the home’s value.
That’s because you cannot maintain a conventional mortgage and a reverse mortgage simultaneously. If you still owe a mortgage balance, you will have to use some of the proceeds of the reverse mortgage to pay the full balance on your conventional mortgage.
An HELOC allows you to maintain your conventional mortgage while taking out the second loan. Home equity lenders will allow you to purchase anywhere from 75 percent to 85 percent of your home’s equity. So if your home is valued at $500,000, and the lender offers a 75 percent line of credit, and you have $300,000 left on the mortgage, you can take out a $75,000 line of credit [(500,000 x 75%) – 300,000].
So you can typically obtain a larger line of credit with a reverse mortgage, but an HELOC will probably be the better option if have considerably less than 100 percent equity in your home.
Main advantages of HECMs
There are two main advantages to choosing an HECM line of credit over an HELOC.
- The amount of credit available to the borrower — the initial amount of credit minus any used funds — increases each month with an HECM.
After the first month of an HECM line of credit, the principal limit increases monthly at a rate equal to 1/12 of the mortgage interest rate in effect at that time, plus 1/12 of the monthly mortgage insurance premium rate. This growth is essentially a further extension of credit based on the previous month’s credit line balance and the current interest rate.
In some cases, the line of credit can grow as much as 5 percent annually. That means if you started with a line of credit of $200,000, in a year that credit line would be $210,000, assuming you did not withdraw any of the available funds.
A HELOC does not offer this feature. Whatever amount you choose to borrow from your home’s equity is the amount you will have available for the life of the loan.
- The other advantage of an HECM is that the borrower does not have to make monthly payments to pay back the loan.
A HELOC is divided into two periods: A draw period during which you borrow funds up to the maximum credit limit, followed by a repayment period during which you pay back borrowed funds plus interest in monthly payments. The draw period can typically last between five years and 10 years, while the repayment period may last from 10 years to 20 years.
You may also have a large balloon payment at the end of a repayment period because of how the loan amortizes. This could occur if your monthly payments were not enough to pay down the entire debt at the end of the loan period. This sometimes happens when interest rates rose during the loan period, which added to the cost of the credit line.
A homeowner who takes out an HECM is not required to make monthly repayments. Instead, the loan proceeds are due when the home is sold or no longer used as a primary residence. All proceeds from the sale beyond the amount owed belong to your spouse or estate. This means any remaining equity can be transferred to heirs. No debt is passed along to the estate or heirs.
Other considerations
Additional differences between an HECM and HELOC include:
- The upfront costs with a reverse mortgage are usually significantly higher than with an HELOC.
- To qualify for an HECM, the property must meet Federal Housing Administration standards and are typically limited to single-family homes. HELOCs are only subject to the property qualifications imposed by the lender.
- Before receiving an HECM, a homeowner is required to meet with a counselor from an independent, government-approved housing counseling agency. The counselor will explain the cost of the loan and other financial implications, as well as alternatives to an HECM. There is no such requirement for an HELOC.
- An HELOC can be closed or reduced at any time by the lender, which may occur if the borrower is not drawing funds from the credit line. An HECM stays open as long as the borrower owns and lives in the home.