Pros and Cons of Choosing a Line of Credit for Your Reverse Mortgage
With a Home Equity Conversion Mortgage (HECM), commonly called a Reverse Mortgage, the borrower can usually choose how they want to receive the proceeds from the loan. The options are typically a lump sum, regular payments over time, or a line of credit. Sometimes, borrowers can opt for a combination of these payout options. In this article, we will explore the benefits and potential drawbacks of choosing a line of credit for your Reverse Mortgage proceeds.
First, let’s review the Reverse Mortgage basics.
With a standard, forward-amortizing mortgage, the borrower is given a loan to cover the cost of their home purchase or refinance and is responsible for paying it off, usually through regular, monthly payments. With a Reverse Mortgage, the process is reversed and the mortgage amortizes backwards. In other words, the borrower takes a loan out against their home’s equity and the lender makes payments to the borrower. With each payment to the borrower, the loan balance increases.
Once the borrower no longer uses the home as their primary residence, the Reverse Mortgage must be repaid. This is usually done by selling the home or, in the event of the borrower passing away, their estate or heirs may arrange to have the loan paid off. The heirs are not obligated to pay off the Reverse Mortgage (unless they wish to keep the home).
How Reverse Mortgage Borrowers Get Money
There are basically three ways to receive your Reverse Mortgage proceeds: in a lump sum, through recurring monthly installments, or a line of credit. Some borrowers can opt to do a combination of these.
If you choose to receive your Reverse Mortgage proceeds in regular monthly payments (sometimes referred to as annuity), each payment causes your loan balance to increase. The benefit of this option is that the borrower will continue to receive monthly payments without worry of them ever running out. In other words, with this option, you can never outlive your income from the Reverse Mortgage proceeds. However, the downside is that this option comes with a higher interest cost and no flexibility – your annuity payment is locked-in. Furthermore, these payments can be considered income by Supplemental Security Income and Medicaid, therefore your SSI benefit payments could be reduced and your Medicaid eligibility could be affected. Last, but not least, as your home equity is depleted by the monthly payouts, fewer assets are available to leave to your heirs. This could make it harder for them to purchase the home after you pass away if they wish, or it could greatly reduce the amount of money they receive once the home is sold (heirs receive any money leftover after the Reverse Mortgage is paid off).
By contrast, the lump sum option, where the borrower receives all of their Reverse Mortgage proceeds in one transaction, offers borrowers a way to access a larger sum of money up front. This can be great for borrowers who need to pay off large expenses quickly; however, the drawback is that your home equity is completely depleted and it would be much more difficult to leave anything to your heirs once you pass away.
By choosing a line of credit, Reverse Mortgage borrowers can avoid two major drawbacks associated with the other payout options: depleting their home equity and inflexibility.
When you choose a line of credit for your Reverse Mortgage loan proceeds, you only owe what you use (plus any associated interest and fees). For example, if you get a Reverse Mortgage line of credit in the amount of $50,000 but you only draw $10,000, you only owe $10,000 (plus interest and fees).
Speaking of interest, with a Reverse Mortgage line of credit, you only accrue interest on the amount that you use. So in our example above, you would accrue interest on $10,000 rather than $50,000. This is a huge advantage over choosing a lump sum, which typically accrue interest on the full loan amount. Likewise, it provides borrowers flexibility that the monthly installments do not. If one month you need a little extra cash, you can draw what you need. The next month, if you don’t need to draw anything, great! Your line of credit will still be there and could possibly even grow.
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Growing Your Line of Credit
Here’s something a lot of people don’t know about Home Equity Conversion Mortgages (HECMs): the unused portion of your line of credit grows at the same rate at which the loan accrues interest.
For example, let’s say your Reverse Mortgage’s interest rate is 3.75%. If the available funds of your Reverse Mortgage line of credit is $50,000 and you don’t touch those funds, then your line of credit will begin to grow monthly based on that rate. After the first month, your line of credit could increase by about $156. And that’s not all. At the start of the next month, you’ll be starting with a higher amount ($50,156) so the line of credit would increase even higher (as long as you didn’t touch those funds). Furthermore, if the variable rate increases, that can also boost the line of credit growth.
With this option, borrowers who exercise restraint can actually access more money later on, if needed. This can come in handy if borrowers face large, unexpected expenses or must deal with an unexpected change in their household income. Because it’s better to have access to these funds before they’re absolutely necessary, many experts advise senior homeowners to apply for an HECM line of credit before they actually need it. That way, if something does come up, the money is there. But if years go by and the money isn’t touched, it will stay put and grow over time without the borrower owing anything. Think of it like a credit card with a limit that increases the more you refrain from using it.
What are the possible disadvantages?
The main disadvantage to choosing a line of credit for your Reverse Mortgage is the variable interest rate. Since the rate is variable, what you owe could fluctuate (assuming you use the line of credit). Again, any unused portion of the line of credit does not accrue interest. Some borrowers are comfortable with a variable interest rate, but if you are not, a fixed rate option may be better for your own peace of mind. Talk to one of our Reverse Mortgage professionals to review the options and find out what works best for you.
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