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Retirement Planning: Home Equity vs. Reverse Mortgage

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Retirement planning and equity
Catherine Miller
Catherine Miller
Jun. 30, 20223 min read
Your senior years are supposed to be your time to kick back and relax. With your family grown up and hopefully taking care of themselves, and more time on your hands now you’re not working, this could be your chance to seize life again.

Trouble is, vacation plans and new hobbies need a bit of cash behind them. Plus, there’s the possibility that your senior years could bring other expenses: healthcare, family emergencies, and even, in some cases, full-time caregiving. With life expectancy these days growing, you could have quite a few years past retirement to include in your financial plan.

In today’s tough economic climate, rising inflation makes cash savings less valuable, and rising interest rates make some forms of loan or credit unwise. That’s why many seniors are looking to release value from their homes, which inflation has made more valuable. But what’s the best way to unlock the cash value of your home?

In this article, we explain two popular options, home equity loans and reverse mortgages, and run through the pros and cons of each.

What is a home equity loan?

A home equity loan lets you borrow money against the value of your home. You can borrow as much as the difference between the value of your home and the balance left on your mortgage (called combined loan-to-value ratio, or CLTV). This type of loan is usually a lump sum, with a fixed rate of interest on repayments over a set term. If you sell your house, you’ll need to repay the loan in full.

Home equity loans are becoming more popular because house values have generally gone up, meaning that many people have a decent amount of equity to draw on.

What are the benefits of a home equity loan?

As this is a secured loan type where you offer collateral, i.e. the equity in your home, in case you can’t repay, it’s generally not too difficult to apply for a home equity loan if you have enough equity remaining in your property. You will usually need a good credit score and the right CLTV, but with these in hand, your rate of interest will probably be lower than many other kinds of loan and credit products.

Because home equity loans have a fixed interest rate, they can also be a great way to secure cheaper repayments than some other loans. With a long repayment term, monthly bills can be quite affordable, even if you’re borrowing quite a large amount.

This type of loan can also be great if you want to invest back into your home. Renovations can raise the overall value of your home, so when you sell it, you can pay off the loan and have money left over.

What are the risks of getting a home equity loan?

Despite the above benefits, it’s worth being cautious about getting a home equity loan. Firstly, if the value of your home doesn’t go up during the loan period, you might end up owing more in the long run, and won’t get that bonus payout when you sell.

You also need to make sure you can actually make the regular payments. If you’re retired, this could be a stretch. Not keeping up your repayments could lead to your house being seized by the bank. The term of your home equity loan is likely to be five to 15 years, so it’s important to be ready to repay for that length of time.

Additionally, consider what you’re using the loan for. If you need it to cover basic expenses, or even luxuries, think about whether it’s worth increasing the amount you owe on your mortgage. Given the long term lengths of these loans, using a home equity loan to consolidate other debts might lead to paying more interest than you would have otherwise.

Should I get a home equity loan?

A home equity loan offers a lump sum that could be really useful. But be aware you’ll need to remain in your property to take advantage, so if you end up needing residential care, it could create problems.

Still, if your retirement income is steady, your health is good, or you’re investing in upgrading your property, a home equity loan could be a good call.

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What is a reverse mortgage?

Homeowners over 62 may be eligible to apply for a reverse mortgage. Unlike a traditional mortgage, where you borrow money to purchase a property and then repay it, with a reverse mortgage, you get a payment from the bank equal to the value of your property (or the equity you hold in it).

Usually, this comes in the form of a Home Equity Conversion Mortgage (HECM), available up to a limit of $970,800. You need to own at least 50-55% of the equity in your home and can borrow a portion of that amount. The payout can be paid in installments (fixed monthly payments, for example), or it can be a lump sum or line of credit.

You won’t need to make repayments until you die or move out of your home. At that point, the proceeds of the sale will form the payment, up to the amount borrowed.

What are the benefits of a reverse mortgage?

The reverse mortgage gives you a degree of flexibility because you can choose how you get your repayments, whether this is in fixed monthly payments, a lump sum, or a line of credit.

A fixed monthly payment could be really important in your senior years, for example, to pay for at-home care. You also won’t need to make regular repayments, which might be easier for you if you’re retired. The money you get is tax-free because it’s considered a loan advance rather than income.

The reverse mortgage locks in the value of your home at the time of borrowing, which means you can continue to benefit from high property values even if they fall over time. Plus, if the value of your home falls lower than the amount owed, your heirs won’t have to pay extra on the balance of the loan.

What are the risks of a reverse mortgage?

There are, however, a few dangers associated with this loan type. You need to continue living in your home, so if you were to need to move into an external senior living facility, for example, you could lose ownership of your property.

You also need to keep your home in good condition, because otherwise the lender won’t get enough money from the sale to repay the loan. If you fail to continue proper home maintenance and the value of the property falls, you may have to repay the loan early. You’re also required to keep up your property insurance and tax payments.

Importantly, if you’re thinking of leaving an inheritance to your family, remember that the proceeds from the sale of your house won’t all go to them; the lender will take their cut first. So, if you use all your equity, there may not be a lot left for your heirs.

There are also a number of additional fees associated with taking out a reverse mortgage, such as origination fees (covering the cost of processing the loan), upfront and ongoing mortgage insurance premiums, servicing fees, and extra charges like credit checks.

And beware: some seniors have fallen victim to reverse mortgage scams, because the idea of getting a regular payout is tempting! So make sure you choose your provider carefully.

Should I get a reverse mortgage?

The reverse mortgage is more flexible than a home equity loan, enabling you to choose how you receive payments and avoid income taxes. But if it’s important to you to leave your property to your heirs, it might not work for you.

So it’s important to do your research before taking out a reverse mortgage. It may even be a good idea to take counseling from a mortgage professional first.

Conclusion

There are lots of reasons you might need access to some money in your senior years. Whether it’s for health care, supporting your family, or pursuing your retirement dreams, unlocking the value of your property could be a good way to boost your cash flow. A home equity loan or a reverse mortgage could be the solution, but make sure to do plenty of research before you commit.

A home equity loan can be suitable if you want a large lump sum to play with, but be aware of the restrictions such as needing to remain in your home. The reverse mortgage is more flexible, but beware of running down your heirs’ inheritance if you’d like to pass your property to them once you’re gone. It’s a good idea to do some careful thinking and potentially get professional advice before you make your decision.

Catherine Miller
Written byCatherine Miller

Catherine Miller is a lead member of personal finance and pension innovator Maji, where’s she’s responsible for content creation and running Maji’s personal finance masterclass, among others. She is also a freelance writer in the fields of finance and education, and holds degrees in English and education.

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