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Line Of Credit or Reverse Mortgage - What Are the Differences?

Posted by  on Apr 16, 2009
 
Reverse mortgages and home equity lines of credit both offer home owners the chance to tap into the equity of their homes, and exchange that equity for cash. However, these options work in very different ways, with different end results for the borrower.

Home Equity Loans and Lines of Credit

These types of loans allow you to borrow money using your home as collateral, and can be taken out even if your home is already mortgaged. With a home equity loan, the amount you borrow is advanced up front, when you take out the loan. The line of credit, on the other hand, works in a fashion that is similar to a credit card”you have a maximum amount you can borrow, but when you choose to borrow the money is up to you.

Both types of loan allow you to exchange the equity in your home for cash, and allow you to borrow an amount of money that is calculated on a similar basis. Most lenders will lend up to 75% of the homes appraised value, less the balance owed on your mortgage. For example, if your home is appraised at $250,000 and you owe $100,000 on your existing mortgage, you may be able to borrow $250,000 x 75% - $100,000, for a total of $87,000.

These two loan types differ in the way interest is charged. The home equity loan interest rate is usually fixed and amortized for up to fifteen years. Alternatively, the borrower can opt for a reduced amortization period in favor of a balloon payment that is due when the amortization period is over. The home equity line of credit interest rate is usually variable, rather than fixed, with a typical draw period (the time in which the borrower can access funds) of between five and 25 years. When the draw period is over, the principal is paid either as a balloon payment or according to an amortization schedule.

The main advantage of choosing a line of credit over an equity loan is that with the line of credit, you pay interest only on the money you draw, rather than the entire sum that you can potentially borrow. However, with both types of loan, your home is the collateral, meaning that defaulting on repayments can potentially lead to foreclosure.

Given that the loan is tied to their most valuable asset, most people choose to use home equity funds only for major expenses, such as college education or medical expenses. A home equity loan or line of credit is also a popular choice for people who are looking to increase their home’s value by remodeling.

Reverse Mortgages

The reverse mortgage also provides the borrower with the chance to tap into their home equity. The most significant difference with the reverse mortgage is that there are no monthly repayments to make, and the loan does not have to be paid back at all until you pass away or sell your home. If either of these situations occurs, the house is sold and the proceeds are used to pay the balance of the reverse mortgage.

Reverse mortgages are typically made available only to those aged 62 years or older who own their own homes. There are virtually no other requirements”neither your credit rating nor your income affects your eligibility. This is usually the easiest way of exchanging home equity for cash for anyone who meets the eligibility criteria.

It is even possible for home owners to obtain a reverse mortgage if they still owe a small amount of money on their conventional mortgage. However, if you obtain a reverse mortgage in this situation you are usually required to pay the balance of your conventional mortgage using some reverse mortgage funds.

Another advantage of the reverse mortgage is that you can choose how to have the money you borrow paid to you. You can choose to receive it as an up-front lump sum, as regular monthly payments, or as a credit card-style account where you draw money as you need it. In some cases you can even choose a combination of these options.

There are some potential pitfalls to be aware of, however. First, a reverse mortgage is subject to finance charges, including loan origination fees. This means either coming up with some cash to pay these charges, or rolling the finance costs into the mortgage. With the latter option, however, you end up paying interest on the finance charges from the beginning of the reverse mortgage.

Another issue that can become a problem for the unwary is that property taxes and insurance are still payable by the owner of the property. While you can’t lose your home, some reverse mortgages have conditions that stipulate that if the borrower defaults on property taxes or insurance, the balance of the loan is due immediately.

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