Real estate can be a worthwhile investment, so it makes sense to consider purchasing more of it. If you own a home and are thinking of buying a second property, it’s important to be familiar with ways to fund the purchase, including with a home equity loan.
To make a larger down payment or purchase a second home or investment property outright, buyers can borrow against the equity in their existing home using a home equity loan. But using a home equity loan to purchase another property comes with its own pros and cons depending on your financial situation, the property you’d like to buy and how you intend to use it.
Whether you’re looking for a summer cabin or investment property, it’s worth exploring home equity loans. We’ll dive into how home equity loans work and the advantages and disadvantages of using equity to buy a second property.
Using a Home Equity Loan To Buy Another House
Home equity loans are a useful way to acquire funds for another real estate purchase. They can be immensely helpful when you’re strapped for liquid cash, or would just rather keep the cash you have for another purpose. But if you’re undecided or need more information, we’ve collected some information to help you decide if using home equity for another home purchase is right for you.
What is a home equity loan?
Sometimes referred to as a second mortgage or home equity installment loan, a home equity loan is a lump-sum, fixed-term loan using the equity in your current home as collateral. Like any loan, you pay back what you borrow plus interest by making payments according to the loan’s terms.
Depending on the purchase price or down payment of your second property, you might need a significant amount of equity in your current home. It’s a good idea to look carefully at your finances so you know exactly how much you need and how much you’ll be able to afford for a monthly mortgage payment.
How do I qualify for a home equity loan?
There are several factors that a mortgage lender considers when determining home equity loan eligibility and loan amounts.
To get a home equity loan, you’ll generally need at least 15% – 20% equity in your home. Also, lenders typically cap the total loan amount at 85% of your home’s fair market value.
What’s the Difference Between Using Home Equity To Buy a Second Home vs. an Investment Property?
Second homes and investment properties are different in a few ways. A second home is another place to live – like a vacation home – in addition to your primary residence. An investment or rental property is one you make money from, most likely by renting it or by flipping the home.
Lenders tend to impose higher interest rates and down payment requirements for a second property if it will be used as an investment property. Why? Lenders typically see a higher risk of default if you’re not planning to live in the home on a semi-regular basis. Lenders might think that you would be more willing to walk away from the property and your mortgage payments if times get tough.
You’ll usually need to make a down payment of at least 10% for a second home and 15% – 25% for investment real estate.
But what if you want this second home to be both a rental property and a home you live in for part of the year? The IRS considers a house a second home (as opposed to an investment property) if you live in it at least 14 days annually, or 10% of the time it gets rented out.
The lines between a second home and investment property may seem a bit fuzzy at times, so it’s important to clarify your goals. You’ll get a better idea of your budgeting needs, submit a more accurate loan application, and avoid headaches later down the line.
Pros and Cons of Using a Home Equity Loan To Buy Another House
Before you commit to a home equity loan for your second home or investment property, weigh the advantages and disadvantages of borrowing against your home’s value.
What are the pros of using a home equity loan to buy another house?
- Potential for larger down payment: If you have enough equity in your home, you can make a larger down payment. This reduces how much you pay monthly and can reduce any mortgage insurance premiums you may need to pay.
- Better chances at approval: Lenders often consider home equity loans less risky since you’re borrowing against your primary residence and are less likely to default.
- Keeps your cash and other assets intact: Rather than putting all of your cash into another down payment, you can use a home equity loan and keep your cash reserves on hand for emergencies or another purpose. Likewise, some people dip into retirement funds or investment accounts to buy more real estate, but a home equity loan helps you keep those accounts as is.
What are the cons of using a home equity loan to buy another house?
- Puts your primary residence at risk: Since you’re borrowing against the value of your home and using it as collateral, you risk losing both properties if you default.
- Increased debt burden: You’ll be paying for a second mortgage each month, which can be difficult if you’re not generating rental or other additional income.
- Potentially higher interest rates: Although they usually carry lower rates than personal loans and other unsecured loans, home equity loans can impose higher interest rates than a first mortgage on your primary residence. Your interest rate ultimately depends on your lender’s standards.
Alternatives to Using Home Equity Loans To Buy Another Home
Home equity loans are worth considering for buying a second property, but it doesn’t hurt to look at a few other financing options. Each financing option carries its own pros and cons, but they’re worth checking out so you know you’re making the right decision for your mortgage needs.
Like a home equity loan, a home equity line of credit (HELOC) also lets you borrow against the value of your home. Instead of a lump sum, however, HELOCs distribute funds via revolving credit so you can take out funds as you need them and only make payments on what you actually borrow.
Because they offer greater flexibility (and higher interest rates) compared to home equity loans, HELOCs are probably better suited for home improvement projects or covering emergency expenses for a second home rather than using the funds for a down payment.
Instead of opening a second mortgage, you can refinance your home and cash out its equity with a cash-out refinance. Refinancing your home can help you get a lower interest rate and provide you a lump sum based on your equity. You’ll have just one mortgage payment with this option, though it might increase your total debt and monthly payments.
If you’re 62 or older, you might be able to use your equity to buy a second home with a home equity conversion mortgage (HECM). You can access your equity without making payments. You would instead repay the loan once you’ve sold the property, moved out or left the property to heirs as part of your estate. Interest still accrues when you’re not making payments, possibly offsetting some of the equity you’ve built.
Hard money loans
Issued by individuals or private companies, hard money loans use properties or assets as collateral. Although they’re relatively easy to get approved for, hard money loans typically come with higher interest rates and shorter repayment terms.
If your equity is tied up in another property, a bridge loan helps you cover the gap in your financing as you transition between two homes. You’ll need at least 20% equity in your home, but you can use a bridge loan to pay off your current mortgage or make a down payment on another property.
In this scenario, the home’s seller and the buyer enter an agreement complete with repayment terms, such as a down payment and an interest rate. It might be hard to convince a seller to agree to seller financing, but if you can, it may lead to more flexible financing than is available via a traditional lender.
With peer-to-peer (P2P) lending, you can cut out the middleman and borrow directly from an investor. An alternative to traditional banks and lenders, P2P lending is based on a social lending system that directly connects borrowers and investors.
If you’re comfortable taking funds out of your retirement accounts, you can put them toward a down payment on a second property. To avoid fees or penalties for withdrawing from retirement funds early, see if you can borrow from the fund and pay it back to yourself with interest.
Keep in mind that personal loans have lower borrowing limits and higher interest rates, but your home won’t be at risk if you default.
Some buyers are fortunate enough to have a chunk of liquid cash in savings that they can use toward a second property. While this is an attractive option, don’t forget that you might be able to make your cash work harder in other investment avenues. And if you put all your savings into a property, you won’t have cash in case of emergencies.
Home Is Where the Equity Is
Tapping into your home’s equity is a great way to purchase a second home or investment property. Although it carries risks – as does any form of debt – you can take advantage of benefits like lower interest rates and higher down payments.
Remember that lenders take a close look at your financial actions (such as new credit or a big purchase) when doing the underwriting on your new loan. So, if you have any questions, hold off on buying new furniture for your second home until you are closer to closing. Then … just enjoy.
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Fannie Mae. “ELIGIBILITY MATRIX.” Retrieved April 2022 from https://singlefamily.fanniemae.com/media/20786/display
Internal Revenue Service. “Topic No. 415 Renting Residential and Vacation Property.” Retrieved April 2022 from https://www.irs.gov/taxtopics/tc415