Following the release of Consumer Financial Protection Bureau's (CFPB) report focusing on reverse mortgage disadvantages and a consumer guide encouraging seniors to try other home equity loan like Home Equity Line of Credit (HELOC), it is but high time to compare and contrast the two loan programs.
HECM: Advantages and Disadvantages
Reverse mortgage, popularly known as, Home Equity Conversion Mortgage (HECM) is a Federal Housing Authority (FHA)-insured program designed to help homeowners aged 62 years and older to tap into their home equity to be a source of cash according to certain payment option. Before I delve into the advantages and disadvantages of this program, let me first clarify what it meant when I said "FHA-insured program".
The claim "FHA-insured" is sometimes stated as "government-insured" or "government loan", which brings confusion to our elderly. Whenever a lender claims that HECM is FHA-insured and uses the latter phrases, consumers thought that HECM is a government entitlement program, which is not. Let me state this point blank: HECM is neither a government loan nor an entitlement program. It is a loan originated by a private lender and then insured by the FHA. Meaning, in case the value of the home upon selling is not enough to cover the senior's home balance, the FHA will pay it off. That's all. This also means that the borrower has the responsibility to pay for insurance fee upfront at loan origination, and each year the borrower is charged an annual insurance fee of 1.25% of the outstanding loan balance. Insurance fee and other fees put HECM loan on the costly side prompting the creation of its lower-cost version, the HECM Saver. I'll discuss HECM options in a separate article. For now, let's take a look at the pros and cons of a reverse mortgage vis-à-vis HELOC.
1.) No monthly payment
2.) No due date
3.) No annual fees to keep the account open and active
4.) Borrower has the flexibility in receiving and paying the loan
5.) If borrower opts for line of credit as a payout option, the unused line of credit grows independent of home value
6.) The bank issuing the mortgage does not own the property
7.) Tax-free income (Not considered an income but a loan)
8.) No minimum income or credit is required to be qualified (The borrower, however, should not have defaulted on any federal debt)
9.) Will not affect Social Security or Medicare benefits
1.) High costs (Include quite a number of fees)
2.) Compound interest (Lenders earn through interest on interest)
3.) May affect need-based benefits like Supplemental Security Income (SSI) and Medicaid
4.) Foreclosure risk due to nonpayment of insurance and real estate tax bills
HELOC: Advantages and Disadvantages
HELOC is a second mortgage that allows a borrower, without respect to age, to convert home equity into cash. The CFPB considers HELOC a cheaper alternative to HECM.
In HELOC, home equity serves as collateral. After a lender examines a borrower's income, debts and credit history, it will set a credit limit, which is usually around 80% of the property's equity. The lender then will set a timeframe during which a borrower can withdraw his money at a pre-established limit. At the end of the borrowing period, the borrower can either renew the credit line or repay the debt. In case that a borrow has exhausted the credit limit prior the end of the borrowing period, disbursement of money will be suspended until payment of some of the outstanding debt is made. Below are the advantages and disadvantages of HELOC:
1.) No mortgage insurance premium (MIP)
2.) Low to no origination fee
3.) No minimum age requirement
1.) Credit and income qualifying requirements
2.) Typically due at the end of 10 years
3.) Can be frozen, reduced or cancelled if the property value decline and overall credit condition tighten
4.) Credit amount is proportional to home value (does not automatically increase)
5.) Generally requires a borrower to pay monthly interest (monthly payment increases as the loan balance increases)
6.) Interest paid may or may not be tax deductible
7.) Annual fee to keep the line of credit open
8.) Foreclosure risk due to nonpayment of monthly interest, tax and insurance.
9.) Borrower has no flexibility (the bank has the right to close the line anytime it deems the move applicable)
HECM has a number of advantages while HELOC has zero to a relatively low processing costs. The strong points of each loan are both desirable, and so, borrowers should compare and contrast each program's advantages and disadvantages vis-à-vis their financial conditions. One of the loans can be advantageous over the other in the long run depending on the borrower's priorities and circumstances. Seniors should plan and seek counseling before availing either loan.
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