How to Borrow Against a Paid-Off House

Home Equity Loan: A Lump Sum With Fixed Payments

A homeowner who needs one known amount, such as the cost of a new roof, is usually describing a home equity loan. With this kind of loan, the lender pays the borrower a single lump sum. The home secures the loan, and the borrower repays it in monthly installments over a set term.

The CFPB explains that a home equity loan taken by someone who already has a mortgage counts as a second mortgage. That second mortgage is paid on top of the first one. On a paid-off house there is no first mortgage, so the home equity loan typically becomes the first lien. A lien is the lender's legal claim against the property.

According to the CFPB's home equity loan guidance, a home equity loan usually has a fixed interest rate, meaning a rate that does not change. The FTC adds that these loans typically have a fixed annual percentage rate (APR), which includes interest and other credit costs. As a result, the payment is predictable. It is also required every month, whatever else happens in the household budget.

Before approving the loan, the lender reviews the home's value and the borrower's finances. The CFPB notes that these loans may carry upfront fees and costs, and that comparing offers means looking at more than the monthly payment alone.

The central trade-off is this: if the borrower cannot repay, the lender could foreclose on the home.

HELOC: Draw What You Need, When You Need It

A HELOC suits a different situation: costs that arrive unevenly over time, rather than one bill. A home equity line of credit is a revolving credit line secured by the home. It works a little like a credit card, except the borrowing is backed by home equity. The CFPB describes it as an "open-end" line that lets the owner borrow repeatedly against that equity.

A HELOC usually has two phases:

• The draw period. During this phase the borrower can borrow, repay and borrow again, up to the credit limit. The CFPB gives 10 years as an example length. The FTC notes that during this phase the borrower may only have to pay interest.
• The repayment period. During this phase no new draws are allowed. The FTC says the borrower must then repay what is owed, either all at once or through payments over time.

HELOCs usually have variable interest rates. A variable rate can change, so the payment can rise or fall from month to month. The CFPB notes that some HELOCs allow part or all of the balance to be converted to a fixed rate. That fixed rate is usually higher but more predictable.

The CFPB also warns about the credit line itself. If the home's value drops significantly, or if the borrower's finances change, the lender might freeze the line or limit further borrowing. The money a homeowner was counting on may then not be available.

The home is collateral, and falling behind could lead to foreclosure. The CFPB's HELOC guidance puts it directly: consider a HELOC only with confidence about keeping up with the payments.

Cash-Out Refinance: Your Home Gets a New Mortgage

The name "cash-out refinance" sounds like a modest adjustment, but on a paid-off home it is a bigger step. The borrower takes out a brand-new mortgage on the house. Normally, the borrower receives the difference between the new loan amount and the old balance as cash. Here there is no old balance, so the borrower receives the loan amount minus closing costs.

What this means for the homeowner is simple to state. A house that was free and clear now carries a first mortgage again. The borrower owes monthly principal and interest payments for the full term of that new loan. Principal is the amount borrowed, and interest is the lender's charge for lending it.

Because a refinance is a full new mortgage, its closing costs can be higher than those of a home equity loan or a HELOC. The lender discloses those costs before the loan closes.

As with the other loans that require payments, the home is collateral. Missed payments can lead to foreclosure.

Reverse Mortgage: Borrowing Without Monthly Payments — and What That Involves

For an older homeowner who cannot take on a new monthly bill, the reverse mortgage is often what the advertising is about. It works differently from the other options, and the differences matter.

A reverse mortgage is a loan for homeowners who meet age and other eligibility requirements. Instead of the borrower paying the lender, the lender pays the borrower under the loan's terms. That money may come as a lump sum, as monthly payments or as a line of credit. No monthly mortgage payment is required while the borrower lives in the home.

The CFPB states that the Home Equity Conversion Mortgage (HECM) is the most common type and is only for homeowners who are 62 and older. HUD explains that the HECM is the only reverse mortgage insured by the federal government. It is available only through a lender approved by the Federal Housing Administration (FHA).

What the borrower takes on

The convenience comes with real obligations, and the CFPB states them plainly:

• The balance grows. Interest and fees are added to the loan balance each month, so the amount owed increases over time.
• The home must stay the principal residence. The borrower must keep living there as the main home.
• Ongoing costs must be paid. The borrower must keep paying the property taxes and homeowners insurance.
• The home must be kept up. The borrower must keep the house in good condition.

The loan comes due when the last borrower dies, sells the home or moves out. The CFPB adds that the loan can come due sooner if the taxes, the insurance or the upkeep fall behind.

What federal law says

The HECM rules are written in 12 U.S.C. § 1715z-20. Under 12 U.S.C. § 1715z-20(d), the borrower, or the borrower's spouse, must be at least 62 years of age "or such higher age as the Secretary may prescribe." The same subsection lists the ways the loan may pay the borrower:

• a line of credit
• monthly payments over a term the borrower chooses
• monthly payments over a chosen term combined with a line of credit
• monthly payments for as long as the borrower lives in the home, which the law calls "tenure"
• tenure payments combined with a line of credit
• any other basis the Secretary considers appropriate

The law also requires counseling before the loan. The borrower must receive "adequate counseling" from "an independent third party" that is not tied to the parties making or funding the loan. To find a counselor, HUD points to its HECM Counselor Roster. Federal rules also limit the origination fee, which is the lender's charge for making the loan. The lender discloses that fee, and HUD publishes the current HECM limits and figures.

A reverse mortgage is not free money, income or a government benefit. It is a loan against the house, and it is one option among several. A fuller walk-through appears in what is a reverse mortgage.

How These Options Compare: What Each One Involves and Trades

Seeing the four options side by side can make a confusing choice easier to sort through. The table below sets out how each one pays out, what it asks of the borrower, and the main risk to the home.

A home equity loan and a HELOC add a loan against the house without writing a whole new first mortgage. A cash-out refinance does write a new first mortgage. The reverse mortgage is the only option here that requires no monthly repayment while the borrower lives in the home. In exchange, interest and charges are added to its balance, so the amount owed grows over time, and the borrower must keep up the residence, taxes, insurance and upkeep obligations described above.

For a closer look at two of these side by side, see the comparison of a reverse mortgage vs HELOC. No single option fits every household. A lender explains the terms of a specific loan, and a HUD-approved counselor walks through how a reverse mortgage compares with the alternatives.

Risks Every Borrower Should Weigh Before Deciding

Every one of these options changes something important: a house that belonged to the owner outright now has a lender's claim on it. For a homeowner who worked for years to own the home free and clear, that is worth weighing calmly and clearly.

• The home is collateral in all four options. If the borrower does not meet the loan's obligations, the home can be at risk.
• Loans with required payments. With a home equity loan or a cash-out refinance, missed monthly installments can lead to foreclosure.
• HELOCs. Variable rates mean the payments can increase over time, and missed payments can also lead to foreclosure.
• Reverse mortgages. The balance grows as interest and charges are added. The loan comes due when the last borrower dies, sells or moves out, and it can come due earlier if property taxes, homeowners insurance or upkeep fall behind.

The CFPB adds one point about long absences. If a borrower spends more than 12 consecutive months in a health care facility, and no co-borrower lives in the home, others living there may have to move out. That rule has exceptions: someone who can repay the loan, or who qualifies as an Eligible Non-Borrowing Spouse, may be able to stay.

The FTC's reverse mortgage guidance says such a loan "can use up much – or even all ─ of your equity." The FTC also describes a "non-recourse" clause, which means the borrower or the estate cannot owe more than the home's value when the loan comes due and the home is sold. For HECMs, 12 U.S.C. § 1715z-20(d) requires a similar limit on what the homeowner can owe.

The FTC further warns about pressure to buy other financial products, such as an annuity or long-term care insurance, with the money from a reverse mortgage. No such purchase is needed to get the loan.

There is also a short window to change one's mind. The FTC explains that a home equity loan or HELOC on a main residence can generally be canceled within three business days for any reason, without penalty. Under the federal rules, those three business days run from whichever comes last: the closing, the delivery of the notice of the right to cancel, or the delivery of the required disclosures. With most reverse mortgages, the CFPB says, the borrower has three business days after closing to cancel for any reason, without penalty.