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Reverse Mortgages Better Than HELOCs

The Mortgage Professor: Is a HELOC better than a HECM?

Oct. 8, 2015

By JACK GUTTENTAG The Mortgage Professor - Tribune News Service

After some deep thought and research, I could find only one situation where a home-equity line of credit, or HELOC, might work better than a home-equity conversion mortgage, or HECM, in meeting the needs of consumers.

In all other situations where both could be used, the HECM worked better for the borrower.

In addition, the HECM can be used for purposes that the HELOC cannot touch at all.

The downside of the HECM, the Federal Housing Administration's reverse mortgage program, is that you must be 62 to qualify.

Definition of HELOC
A HELOC is a loan set up as a line of credit for some maximum draw, rather than for a fixed dollar amount.

For example, with a $150,000 HELOC, the borrower receives the lender's promise to advance up to $150,000 in an amount and at a time of the borrower's choosing.

HELOCs have a draw period, during which the borrower can use the line, and a repayment period, during which it must be repaid. Draw periods are usually five to 10 years, during which the borrower is only required to pay interest.

Repayment periods are usually 10 to 20 years, during which the borrower must pay off the entire balance.

HELOCs can be first mortgages or second mortgages, which the lender typically retains in its portfolio without insurance.

Definition of HECM
An HECM is designed to allow elderly homeowners who have equity in their homes to convert some or all of it into spendable funds. They can draw the funds at closing, intermittently as needs arise, or in the form of monthly payments for as long as they reside in the house or for any specified shorter period.

Repayment of a HECM is not required until the borrower dies or moves out of the house permanently.

To qualify for a HECM, however, borrowers must be 62 or older.

HECMs are always first mortgages, are insured against loss by FHA, and are almost always sold by the lenders originating them.

HELOC Credit Line Versus HECM Credit Lines
  • Credit line differences:
    Both HELOCs and HECMs provide borrowers with credit lines using adjustable rate mortgages.
    Upfront fees are substantially lower on the HELOC, but the HELOC borrower must pay interest on line usage immediately and must repay the entire balance within the repayment period.

    In contrast, HECM borrowers who draw on credit lines are not obliged to make any payments so long as they reside in the house.

    There are also important differences in how credit line amounts change over time.

    With a HECM, the portion of the credit line that is not used grows month by month at the interest rate on the HECM. The lender has no discretionary control over this process.

    With a HELOC, in contrast, the amount of the initial line does not change unless the borrower can negotiate an increase, which is uncommon. But lenders reserve the right to freeze lines that have not yet been fully used, and they do so when adverse information emerges about the borrower's credit or the market in which the borrower is involved.

    These differences affect how the different lines can be used for various purposes.

  • Meeting intermittent but temporary expenses:
    A borrower 62 or older faced with the need to finance outlays that will occur intermittently over future months -- financing additions to a home, for example -- can finance them with either a HELOC credit line or a HECM credit line. In both cases, they will be borrowing with an adjustable rate mortgage that exposes them to the risk that interest rates will rise during the draw period.

    If the borrower intends to repay the balance shortly after the outlays have been completed, the HELOC probably will be more cost-effective, because the initial interest rate and upfront fees are lower. However, over extended periods borrowers are more exposed to interest rate increases on HELOCs because rate maximums are higher and there are no rate adjustment caps as there are on HECMs.

  • Managing fluctuations in income:
    Both HELOCs and HECMs can be drawn against when income is low, and repaid when income is high.

    With a HELOC, however, this can be done only during the draw period.

  • Protecting against adverse future contingencies:
    credit lines grow over time, they provide insurance against a wide range of adverse contingencies, including loss of pension income resulting from the death of a spouse, and exhaustion of the financial assets that were supposed to last a lifetime but didn't. HELOCs don't have this capacity.

Other Uses of HECMs That Are Not Available With HELOCs
  • With an HECM you can buy a house and not repay the mortgage used to finance the purchase so long as you live there.

    You can't do that with a HELOC.

  • With an HECM you can supplement your monthly income by borrowing a set amount each month, with no required repayment for as long as you reside in the house. This is called a "tenure" payment if it continues for as long as the borrower resides in the house, and a "term payment" if it terminates after a specified period.

    Neither is available on a HELOC.

About the Writer
Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania.

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Copyright (c) 2015, The Mortgage Professor

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