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What is the difference between a home equity loan and a reverse mortgage?
One benefit of owning a home is building equity, making it a place to live and often a valuable investment. You can then use this equity to pay for planned or unplanned expenses or even fund your retirement. Depending on your needs, you’ll need to take out either a home equity loan or reverse mortgage to access this equity.
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This article is over two years old, last updated on August 23, 2022. While RateCity makes best efforts to update every important article regularly, the information in this piece may not be as relevant as it once was. Alternatively, please consider checking recent home loans articles.
Equity is the difference between your outstanding loan amount and the market value of your property. When you take out a home loan to purchase a property and begin to repay it, you accumulate equity. This equity can then be accessed to help you with other financial commitments or new purchases. An increase in your property’s price due to market forces will also boost your equity by increasing the property’s market value.
How can you access the equity in your home?
You can access the equity in your property by applying for a lump sum or line of credit equity home loan, or a reverse mortgage. An equity home loan (or home equity loan) allows you to borrow money against your home. If you’re a retiree, you can also consider a reverse mortgage that allows you to access a part of the value of your property as a lump sum or an ongoing income stream.
What is a home equity loan, and how does it work?
A home equity loan is a type of loan that allows you to release some of the equity you have built in your home. You can use a home equity loan for any purpose, such as travelling, paying for medical expenses, consolidating your debts or renovating your property. Lenders don’t usually enquire about the purpose of a home equity loan, but remember this will differ from lender to lender.
A home equity loan can be set up either as a lump sum or a line of credit. A lump-sum loan lets you borrow a certain amount, and you repay it along with interest over the loan term. A line of credit works a bit differently as you draw on the funds gradually.
If you choose to go with a line of credit equity home loan, the lender will approve a predetermined limit which will typically be about 80 per cent of the equity you have in your home. These funds can then be accessed when required without having to notify the bank or lender. You’ll need to make repayments to ensure you stay under the credit limit, including any interest charged, but interest is only charged on the amount you withdraw.
What is a reverse mortgage and how does it work?
If you’re over 60, you can use a reverse mortgage to access some of the equity you’ve built up in your home. If you’re under 60, a reverse mortgage isn’t available to you.
Like a home equity loan, you can use a reverse mortgage to borrow a lump sum, set up a line of credit or an income stream to support your retirement. However, there is no requirement to make any immediate repayments on a reverse mortgage. Lenders typically receive full repayment of the loan when the house is sold, or the borrower moves into aged care or passes away. This means you can continue living in your home while enjoying some extra income in retirement with a reverse mortgage.
There are risks associated with this type of loan, including a high interest rate that is compounded onto the loan. This can make the total debt accumulate quickly and erode your home equity faster.
What’s the difference between a reverse mortgage and home equity loan?
The biggest difference between a home equity loan and a reverse mortgage is that reverse mortgages are restricted to people over 60. If you’re over 60, you can borrow money for personal expenses either through a reverse mortgage or a home equity loan. And if you’re under this age, you can only access the equity in your home through a home equity loan.
A home equity loan generally doesn’t have a fixed term and may be added to your loan balance and paid over its remaining term. This will see you paying more towards your home loan every month, which could put pressure on your household budget. If you set up a line of credit, you’re generally not required to make any repayments until you reach your credit limit. You can also opt to make interest-only repayments in the initial years of the term and repay the borrowed amount later. While this can help you keep your costs down in the short term, this strategy could cost you a lot of money in interest. It may also burden you with a large amount of debt at the end of the interest-only period.
If you’re eligible for a reverse mortgage, you’re not required to make any immediate repayments, except the general costs of setting up the mortgage in some cases. A reverse mortgage can run until you sell your property, move into aged care, or pass away. During this time, the interest charges accumulate and can quickly add to your debt due to the relatively high interest rates offered on reverse mortgages. Reverse mortgages are typically repaid in full when the property is sold.
Due to the age restrictions on reverse mortgages, they’re typically used to help you transition into aged care and pay for medical or similar expenses that come with old age. However, you need to be cautious that you don’t use all the equity in your property. If you use all your equity for a reverse mortgage when you move out and sell the property, the proceeds will be used to repay the loan leaving you with nothing to help pay for any living expenses you may have. You’ll be protected from further debt once you sell your home, however; the lender can never charge you more than the value of your house. But you will need to have negative equity protection built into your agreement to get this protection.
Usually, it’s difficult to say which of the two options is better for an individual. If you meet the age requirements of a reverse mortgage, you may consider looking into one, depending on your circumstances. But given the age restriction on reverse mortgages, if you’re under 60, you can’t even consider it. You can only look at home equity loans. Both options are separate financial products and impact your lifestyle and finances in different ways.
It’s generally a good idea to speak to a financial expert or a mortgage broker. They’ll help you understand the difference between a reverse mortgage and home equity loan and what they will cost you over time to make an informed choice.
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