Thinking about leveraging your home equity during retirement?
A lot of homeowners do this with HELOCs and HECMs. In this article, we’ll explain what these letters stand for, how these loans work, and how they’re different from each other.
Using these details, you can decide which type of home equity loan to use.
HECM vs HELOC: what’s the difference?
- HECM (pronounced “heck-um”) stands for Home Equity Conversion Mortgage. A HECM is a reverse mortgage, meaning it does not require monthly payments. Instead, the loan balance comes due when you move out or pass away
- HELOC stands for Home Equity Line of Credit. This loan requires monthly payments. Most HELOCs must be repaid within 20 to 30 years or when the home sells
When is a HECM better?
Home Equity Conversion Mortgages work well for retirees who:
- Are 62 years old or older: At least one borrower has to be 62 to apply for a HECM
- Will live in the home: HECMs require at least one borrower to use the home as their primary residence
- Have lower or fixed incomes: Since they’re reverse mortgages, HECMs can generate cash without requiring a monthly payment
- Want to protect other assets: Cash from a HECM can buy time while other assets mature
- Want to avoid variable payments: HELOCs come with variable interest rates which means its rate will change
- Want to avoid rising payments: HELOC payments also change based on the amount of credit in use. And, the loan’s payments will go up, usually in 10 years, when the HELOC enters its repayment period
- Want to avoid a frozen credit line: HELOC lenders monitor borrowers’ financial lives. A lender could freeze a HELOC if a borrower’s credit score decreases or if the home loses value
- Can’t qualify for a HELOC: Reverse loans like HECMs don’t require payments, so the borrower’s income matters less than other factors, such as the ability to maintain the home, pay its property taxes, and keep it insured
A HECM is one type of reverse mortgage; other types are available too. Learn more about reverse loans here.Check your eligibility for a reverse mortgage.
When is a HELOC better?
A Home Equity Line of Credit works well for homeowners who:
- Are not old enough for a HECM: HECMs work only for borrowers who are 62 or older; HELOCs have no age requirements
- Will live elsewhere: It’s possible to open a HELOC on a property you own but don’t live in — not so with HECMs
- Can afford a monthly payment: Making monthly payments will save on long-term interest and fees
- Want a monthly payment: Repaying the HELOC restores the borrowed equity which means heirs won’t be responsible for the debt later
- Need cash faster: Homeowners can open a HELOC within a couple weeks; HECMs take longer to close and start delivering money
- Want to save on closing costs: Upfront costs to open a HELOC normally come in well below HECM closing costs
- Have less equity: It’s possible to borrow up to 100% of a home’s equity with a HELOC; HECMs limit you to tapping only 40-50% of your available home equity
- Want to keep two mortgages: HELOCs can be placed on top of another mortgage; a HECM would have to pay off any other existing mortgages before any cash payouts
How are HELOCs and HECMs similar?
The differences between HELOCs and HECMs are key factors when deciding which type of loan you need. But these loans’ similarities can help answer that question, too.
So how are HELOCs and HECMs alike?
Both loans can provide access to a use-when-needed credit line
By definition, a HELOC is a line of credit. Instead of receiving a large sum of money, the borrower can withdraw money from the credit line as needed. In that way, a HELOC resembles a credit card except with a much lower interest rate.
A HECM can do this, too. With a HECM, borrowers don’t have to get a large sum of cash. They don’t have to receive regular monthly payments, either. Instead, they can set up a credit line to draw from as needed.
By choosing a credit line instead of a lump sum or monthly payments, a HECM borrower can combine the strengths of both loan types: the lower balance, interest, and fees of a HELOC and the zero-monthly payment of a HECM.
Both loans must eventually be repaid
Though no payment is due monthly, a HECM must be repaid eventually.
When you open a HECM or a HELOC, the lender places a lien against your home. Through its lien, the lender can claim part ownership of the home if the loan isn’t repaid as agreed.
This isn’t all bad. This is a reason interest rates on these loans are lower than for unsecured loans like credit cards.
But it’s important to know this going in: If you don’t pay off the loan, your heirs will have to, even if they have to sell or forfeit the house to do it.
Both loans provide tax-free money
Since reverse loans like HECMs are retirement products — and since they can pay out a monthly income — some borrowers wonder whether they’d need to pay income taxes on the money.
They don’t. Even though it seems like a source of income, a HECM — like a HELOC — is a loan, and borrowed money isn’t taxed like income. Since it’s not taxable income, the money shouldn’t affect Medicare premiums either.
Borrowed money could affect Medicaid or SSI payments. Those programs base eligibility on your assets which includes money in the bank for more than 30 days, regardless of where the money came from. (You could dodge this problem by using a HECM credit line instead of receiving a lump sum.)
Both loans charge interest
This will seem obvious to most borrowers: Both HECMs and HELOCs charge interest. But it’s not as obvious as you might think.
As a reverse loan requiring no payments, a HECM’s interest can seem hidden. The interest charges — and the annual fees — add money to the loan’s balance as time passes. If years, or decades, pass, the loan’s balance could grow a lot.
Thanks to the HECM’s FHA insurance, heirs won’t be responsible for any portion of the loan that grows beyond the home’s value. Still, borrowers who can afford to pay the HECM’s interest and fees each year shouldn’t need this FHA safety net.
HELOC vs HECM: How should you access your home equity?
If you can afford its monthly payments, a HELOC has a big advantage: With each payment, you recharge your home equity. You can use the equity again, later. In fact, the same HELOC can be used, repaid, and reused repeatedly during its draw period, which usually lasts 10 years.
You can pay off HECMs, too, but you don’t have to. It’d be up to you, the borrower, to schedule and make payments. If you don’t, and if enough time passes, all of your home’s value could belong to the lender. The lender would sell your home to pay off the debt after you die or move out.
This is fine for borrowers who need cash today more than they need home equity tomorrow. But borrowers who want to control as much equity as possible should choose a HELOC or make voluntary payments on their HECM.See if you qualify for a reverse mortgage.