More than three-quarters of people ages 50 and older want to continue living in their homes as long as possible. But it’s not always easy. Many retirees live on fixed incomes that can make it difficult to pay for the rising cost of living and for major expenses such as medical care.
While many older homeowners are strapped for cash, they often are “house rich” at the same time. Nearly 80% of adults 65 and older own their homes, and such homeowners have on average $143,000 in equity,which is the difference between what their home is worth and what they owe on it.
Equity is a resource that qualified older homeowners can tap into to pay their expenses — and continue living in their homes — with a reverse mortgage or a cash-out refinance. While both options let homeowners access their equity, they work in very different ways. Homeowners should consider the benefits and disadvantages of each before deciding on one or the other.
Read on to compare reverse mortgages vs. cash-out refinances:
- What Is a Reverse Mortgage?
- What Is a Cash-Out Refinance?
- Reverse Mortgage vs. Cash-Out Refinance: The Differences
- When Is a Reverse Mortgage Better?
- When Is a Cash-Out Refinance Better?
- The Bottom Line on Reverse Mortgages vs. Cash-Out Refinances
What Is a Reverse Mortgage?
A reverse mortgage is a loan that qualified older homeowners can use to borrow a portion of their home’s equity while continuing to live in it. Instead of the homeowner paying the lender and reducing the principal owed, the lender pays the homeowner and increases the principal owed.
The most common type of reverse mortgage is a home equity conversion mortgage, which is available only through lenders approved by the Federal Housing Administration to homeowners ages 62 and older.
The money that’s paid out in a reverse mortgage is usually tax-free, and has no effect on the homeowner’s status with benefits such as Medicare or Social Security. The borrowed money can be disbursed as a lump sum, a monthly payment, a line of credit, or a combination of those options.
Over time, the principal on a reverse mortgage will increase and accrue interest. The loan must be repaid when the borrower no longer lives in the home — usually because they’ve moved out, sold the home, or died. The borrower, or their family or estate, often will sell the home to repay the principal on the reverse mortgage.
What Is a Cash-Out Refinance?
A cash-out refinance is loan where qualified homeowners take out a new mortgage for more money than they owe on their current one, and keep the difference.
For example, if you owe $120,000 on your mortgage and your home is worth $250,000, you could refinance with a new mortgage for $200,000. After paying off the original loan, you would have $80,000 to use as you like. The entire amount is repaid as part of the new mortgage.
How much equity you can borrow with a cash-out refinance depends on the lender’s terms, your home’s loan-to-value ratio, and your credit score.
Cash-out refinancing also could help homeowners save money if they can get a lower interest rate on their new loan, or change their loan term either to make their mortgage more affordable or to repay it more quickly.
How much can you get with a cash-out refinance?
Even if you have plenty of home equity, you can’t borrow the whole amount. You typically can refinance up to 80% of your home’s value, though that varies depending on which type of mortgage you choose.
How much of that equity you receive as cash will depend on what you owe on your current mortgage. You’ll also have to pay refinance closing costs, which are about $5,000 on average.
Reverse Mortgage vs. Cash-Out Refinance: The Differences
When it comes to a cash-out refinance vs. reverse mortgage, it’s important to understand the differences. Your age, your finances, how much you’re looking to borrow, and market conditions all play a role in deciding which option is best for you.
Disbursement and repayment
Repaying a cash-out refinance is just like repaying your previous mortgage. You make monthly payments to the lender — possibly for a larger amount, and for longer than you would have with your previous mortgage.
In the case of reverse mortgages, you make no monthly payments. While that may sound great, keep in mind that the balance on your reverse mortgage will grow with each payment — and you’ll be charged interest on that balance until it’s repaid.
Reverse mortgage requirements differ from those for a cash-out refinance. The borrower must be 62 or older, and the reverse mortgage must be for the borrower’s primary residence.
Borrowers also need at least about 50% equity in their home. The home must be in good shape, and the borrower must be able to continue paying for homeowners insurance and property taxes.
As for a cash-out refinance, borrowers essentially must meet the same criteria for getting a mortgage as if they were buying a home.
The borrower’s credit score plays a big part in determining how much they can borrow and at what interest rate. A score of at least 620 typically is needed.
The borrower must also have been on the property’s title for at least six months, and a new appraisal and inspection report may be required. The borrower usually must have at least 20% equity in the home.
Impact on equity
One of the biggest differences between reverse mortgages and cash-out refinances is how they affect equity.
When you take out a reverse mortgage, the money is paid directly to you as long as you live in the home. But your balance will increase while your equity in the home decreases. When it comes time to sell, you’ll keep less of the proceeds.
Conversely, a cash-out refinance requires a monthly payment to pay back the new, larger mortgage you took out. As you make payments, your balance will decrease and your equity will increase. If your home increases in value and you pay down your balance, you’ll have more equity to keep when you sell the home — up to 100% if you pay off your new mortgage completely.
When Is a Reverse Mortgage Better?
A reverse mortgage lets you use your equity now and repay it in a lump sum later. This type of loan is intended to help older homeowners continue living in their home in their later years. The trade-off is they use their equity to do so, and may have less to pass on to their heirs.
As long as you plan to stay in your current home, your taxes are all up to date, and you don’t plan on passing on your home to family or heirs, a reverse mortgage could be right for you, says Linda McCoy, a mortgage broker based in Mobile, Alabama, and board president of the National Association of Mortgage Brokers.
“The perfect couple for a reverse mortgage is retiring, in their late 70s, have a lot of equity in their home, and they now want to enjoy the years they have left,” McCoy says. “With a reverse, they can take a large chunk of money out to put into their bank, pay off all their bills, and get some golf clubs and go play and travel knowing there is money in the bank to pay their normal bills with no mortgage payment.”
When Is a Cash-Out Refinance Better?
A cash-out refinance decreases your equity with a one-time hit when you take it out, but you can rebuild your equity over time as you make payments. That can leave older homeowners taking out a cash-out refinance with more equity when they sell the house, or to pass on to their family or heirs.
Cash-out refinances are the only option for homeowners who don’t meet the minimum age for a reverse mortgage. They also could be right for older homeowners who need cash now but can continue making monthly payments to reduce their mortgage balance.
“The perfect cash-out client would be one that had a lot of equity in their home and wanted to remodel, take cash out to consolidate all they owed, and add on that room at the same time, with no private mortgage insurance and get a lower interest rate than their previous mortgage,” McCoy says.
The Bottom Line on Reverse Mortgages vs. Cash-Out Refinances
Your home is one of the biggest investments you’ll ever make. Over time, your equity will become an asset that grows while you get older. By being able to leverage that equity through a reverse mortgage or a cash-out refinance, you can take care of other financial needs in your later years. Understanding how these loan types differ will help you choose the option that best fits you.