The reverse mortgage and the pay-option mortgage are two surprisingly similar home mortgage options that are both worth considering by senior homeowners wishing to tap into their home equity.  Many seniors in recent years have used the option-ARM to access cash from their home equity, which results in far lower monthly payments for the same loan amount than those of the traditional 30 years fixed rate mortgages. Others have opted for a reverse mortgage to accomplish the same goal of accessing their home equity, but without the requirement of any monthly principle or interest payments. Given these loans' similar function to access home equity with a low or no payment burden, which loan is better for seniors?

A good place to start this discussion is with a definition of each type of loan. A reverse mortgage is a home loan for people over the age of 62 that enables them pull out some of their home equity as cash.  This money can be used for any purpose that they want. A defining element of this mortgage for seniors is that it never requires a monthly mortgage payment for the life of the loan. The loan may be kept until the homeowner(s) either sell the home or permanently move out. Essentially, a reverse mortgage is similar to a line of credit, in that it has a credit limit and the ability to take cash out and put it back in. The senior does not pay the monthly interest that accrues, but instead the interest gets added to the principle balance.  The lender actually cannot ask the homeowner for any payments for as long as they live in the home. When the home is sold or the loan is refinanced, the total amount borrowed (principle plus interest), is repaid to the lender.

Now for a definition of the pay-option mortgage. You may hear of it referred to by a number of different names, such as "option ARM", "pick-a-payment", "negative amortization loan", or "deferred-interest loan" among others. The pay-option mortgage has no age requirements so a homeowner of any age may take out this loan.  Like the reverse mortgage, a homeowner may pull out a lump sum of equity (no credit lines), while taking on only a relatively small mortgage payment.  You can usually expect a mortgage payment between 2% and 5% annually of the loan balance, but paid monthly (take 2% to 5% and divide by 12). However, that payment does not equal the interest rate on the loan, which may be 6% to 12%. For example, if the payment is 5% and the interest rate is 8% (a common scenario), then the interest that is not being paid is 3% (8% minus 5%).  Similar to a reverse mortgage, the lender allows that 3% of unpaid interest to be added to the principle balance of the loan, and repaid at a later date. Thus, even though payments are being made, the loan balance grows over time. But the loan balance is not allowed to grow indefinitely. Once it reaches 110% to 115% of the original loan balance (depending on the lender), a full mortgage payment must be made.

There are several factors to consider when comparing the reverse mortgage to the pay-option mortgage. If the senior intends to live in their home for many years to come but does not have an abundance of income, then the pay-option mortgage would be a poor choice. It would be like waiting for a bomb - it is only a matter of time until the low monthly mortgage payment would be replaced by a much bigger monthly payment. In this scenario, the reverse mortgage would be a better choice since it carries the guarantee of no mortgage payments for as long as the homeowner lives in the home.

The pay-option mortgage is more difficult to qualify for than the reverse mortgage because it requires documentation of good income, assets (other than home equity) and credit score. The reverse mortgage does not require any of those items.  Caution: An overly eager broker might point out that your pay-option mortgage only requires these items to be "stated" on the forms by the borrower. If in your case "stating" ample amounts of income or assets means "lying", despite what your broker might say, such an action carries potential loan-fraud consequences.

In most cases, a reverse mortgage will cost far less than a pay-option mortgage.  Although the closing costs will probably be similar amounts, the interest rates for pay-option mortgages are 1% to 3% higher. More important, is the fact that you must take all the money immediately as one lump sum with the pay-option mortgage rather than taking it out when you need it, as in the case with a reverse mortgage credit line arrangement. Having a line of credit allows the loan interest to accrue against a smaller balance, because you are keeping the mortgage balance lower for a longer period of time. The only offsetting factor in favor of the pay-option mortgage is that a portion of the interest is being paid each month.

Seniors are well advised to consider a reverse mortgage before committing to an pay-option mortgage.  The pay-option mortgage tends to best serve working people who need to free up some monthly cash flow for a period of time and are willing to trade some of their equity for that privilege. But in most cases, reverse mortgages for seniors are a far better long-term choice.