Both reverse mortgages and home equity loans are financing options related to homeownership, and each is suited to specific borrowers and financial situations. That is just about where the similarities end, however, as both the purpose and process of reverse mortgages and home equity loans are completely different. Understanding these two financing options and the difference between them can help you to understand which type of financing is best for your personal situation.
A reverse mortgage, just as the name implies, works just like a mortgage, but in reverse. Rather than paying out a lump sum and requiring monthly payments, like traditional mortgages, reverse mortgages make monthly payments to borrowers, requiring a lump sum repayment at the end of the mortgage.
Reverse mortgages are designed to help elderly citizens meet their existing traditional mortgage obligations. The fact that borrowers can use reverse mortgage payouts for anything they wish makes this a more robust financing option. Individuals can use a reverse mortgage to pay for living expenses, for example, relying on life insurance payouts to cover the repayment obligation in the future.
Home Equity Loans
A home equity loan shares the lack of restrictions on the use of funds featured by reverse mortgages. While this type of loan is directly tied into homeownership, home equity loans are rarely used to purchase real estate. A home equity loan uses your home's current net value -- its market value less any outstanding mortgage balance -- as collateral for a secured debt obligation. Home equity loans can be ideal for people who fully own their homes, or who are close to paying off their mortgages, as the potential amount of these loans goes up as mortgage balances go down.
Reverse mortgages provide distinct advantages to elderly people who might not otherwise be able to make their regular mortgage payments. Inflation and rising home values can eat away at the purchasing power of retirees' fixed incomes; a reverse mortgage can allow someone to remain in his home for the remainder of his life, rather than being uprooted in his retirement years.
Home equity loans, as secured debts, have advantages over unsecured bank loans. Secured loans generally feature more attractive terms than unsecured debt, since secured loans present less risk to lenders. These loans can provide the money needed to perform renovations or build additions to recently paid-off homes.
Reverse mortgages' repayment structures present risks to both borrowers and their families. Reverse mortgages are due back in full at maturity, which can be virtually impossible for most individual borrowers. Reverse mortgage terms may also stipulate that the entire amount is due in full if the borrower moves out of her current home. If a reverse mortgage borrower passes away, and there is not enough money in the estate to cover the obligation, the borrower's family can end up with a very large obligation.
The secured nature of home equity loans introduces risks in addition to the advantages. Defaulting on a home equity loan can cause borrowers to lose their homes in the worst case scenario, even if they declare bankruptcy.