Buying a home can provide more than just a place to live, because you can borrow against the value of your home. As you pay off a mortgage, the value of your home that exceeds your loan balance -- your home equity -- tends to grow. Home equity loans and reverse mortgages are two common types of financial products that let you trade home equity for cash.
Home Equity Loans
A home equity loan is a second mortgage that trades away home equity for cash you can use for any purpose. For example, if your home is worth $300,000 and you have $200,000 left on your original mortgage, you have $100,000 of home equity. If you take out a $40,000 home equity loan, you gain $40,000 in cash, but your total debt balance goes up to $240,000 and your home equity falls to $60,000. Lenders consider your credit score and income when deciding whether to approve you for a home equity loan. A home equity line of credit is an alternative to a normal home equity loan where you can borrow against your home equity as necessary up to a predetermined limit instead of taking a single lump-sum payment.
A reverse mortgage is a financial product that lets seniors borrow against home equity. You must be at least 62 to take out a reverse mortgage and you typically need to have paid off your original mortgage in full or have a small remaining balance that you can pay off with a portion of your reverse mortgage. With a reverse mortgage, you can borrow money as a series of monthly payments, a lump sum payment or a credit line. Your income and credit score don't matter when applying for a reverse mortgage, because you don't have to make payments for as long as live in the home.
A home equity loan is just like a normal mortgage in that you have to make payments on the loan each month. On the other hand, you don't make monthly payments on a reverse mortgage. Instead, interest accrues on a reverse mortgage each month, but you don't have to pay off the amount you borrow or the interest until you sell your home, move or pass away. With a home equity loan, you are expected to pay back your loan over time with your income, but with a reverse mortgage lenders are repaid from the proceeds of the sale of the home.
The Internal Revenue Service lets you deduct up interest paid on up to $100,000 of home equity debt each year. Home equity debt includes balances on normal home equity loans and home equity credit lines. While a reverse mortgage involves borrowing against equity, you can't deduct interest that accrues on a reverse mortgage, since you don't actually pay the interest as it accrues. You can deduct reverse mortgage interest in the year you actually pay it, although the deduction is generally subject to the same $100,000 limit that applies to home equity debt.
- TD Bank: Home Equity Frequently Asked Questions
- Federal Trade Commission: Reverse Mortgages
- U.S. Department of Housing and Urban Development: Frequently Asked Questions about HUD's Reverse Mortgages
- ABC News: Reverse Home Mortgage - Risks vs. Rewards
- Internal Revenue Service: Publication 936 - Main Content
- Kiplinger: New Lower-Cost Reverse Mortgage Option
Gregory Hamel has been a writer since September 2008 and has also authored three novels. He has a Bachelor of Arts in economics from St. Olaf College. Hamel maintains a blog focused on massive open online courses and computer programming.