If you own a home and are thinking of buying a second one, a home equity loan might be a great way to do it. If you’re looking to make a larger down payment or purchase a second home or investment property outright, you can borrow against the equity in your existing home by using a home equity loan.
But using a home equity loan to buy another property comes with pros and cons depending on your financial situation, the home you’d like to buy and how you intend to use it.
Whether you’re looking for a summer cabin or an 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 home.
Using a Home Equity Loan To Buy Another House: What To Know
Home equity loans are a useful way to get the funds you need for another real estate purchase. They can be immensely helpful when you’re strapped for cash, or you’d rather keep the cash you have for another purpose.
But if you’re undecided or need more details, we’ve collected some information to help you decide if using home equity to purchase another home 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 that uses 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 home, you might need a significant amount of equity in your current home. Look carefully at your finances to know exactly how much you’ll need. Keep in mind that you’ll also have to pay closing costs, so include that in your total budget as well.
How do I qualify for a home equity loan?
A mortgage lender considers several factors when determining home equity loan eligibility and loan amounts.
To get a home equity loan, you’ll generally need more than 15% – 20% equity in your home. Also, lenders typically cap the total loan amount at 75% – 85% of your home’s fair market value.
Let’s say your loan is $400,000, you owe $215,000 and your home hasn’t increased in value. Your lender says you can access up to 85% of the home’s value, which is $340,000 before subtracting what you still owe. So in this case, you can borrow up to $125,000.
Other eligibility factors are your income and credit history. You’ll usually need a debt-to-income (DTI) ratio of 45% or lower and a credit score of at least 640.
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 and those differences influence how much equity you’ll need to purchase it. A second home is another place to live – like a vacation house – in addition to your current home. While an investment or rental property is one you make money from, likely by renting it or flipping the home.
Because you don’t live in your investment property, lenders tend to impose higher interest rates and down payment requirements for a second home if it’s used as an investment property. Why? Lenders might think you’ll be more willing to walk away from the property and your mortgage payments if times get tough.
Because of this risk you’ll usually need to make a down payment of at least 10% for a second home and 15% – 25% for investment real estate. That’s a big difference in upfront costs that you’ll need to consider before taking out a home equity loan to pay for it.
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 will tax a second home as an investment property unless 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 an investment property may seem a bit fuzzy at times, so it’s important to clarify your goals. This way, you’ll get a better idea of your budgeting needs, submit a more accurate loan application and avoid headaches later.
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.
If you have enough equity in your home, you can make a larger down payment. This reduces how much you’ll pay monthly and can reduce any mortgage insurance premiums (MIPs) you may need to pay.
In contrast with a second mortgage, lenders often consider home equity loans less risky, since you’re borrowing against your current home and are less likely to default.
Rather than putting all of your cash into another down payment, you can use a home equity loan and keep your cash reserves for emergencies. Similarly, 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.
Since you’re borrowing against the value of your home and using it as collateral, you risk losing both homes if you default.
You’ll be paying for a second mortgage each month, which can be difficult if you’re not generating rental or other additional income.
Although they usually carry lower rates than personal loans and other unsecured loans, home equity loans have higher interest rates than a first mortgage on your primary residence.
Alternatives to Using a Home Equity Loan To Buy Another Home
Home equity loans are worth considering for buying a second home, but it doesn’t hurt to look at other financing options. Each 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.
Some buyers are fortunate enough to have savings 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 of your savings into a property, you won’t have cash in case of emergencies.
Like a home equity loan, a home equity line of credit (HELOC) also lets you borrow against the value of your home. However, instead of a lump sum, HELOCs distribute funds through revolving credit. This way, you can take out funds as you need them and only make payments on what you actually borrow.
Because they offer greater flexibility – and variable interest rates – compared to home equity loans, HELOCs may be 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 taking out 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.
In this scenario, the home 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 what’s available via a traditional lender.
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.
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 – like any form of debt – you can take advantage of benefits like lower interest rates and higher down payments.
Remember that lenders will 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 or concerns, hold off on buying new furniture for your second home until you’re closer to closing.
Fannie Mae. “Eligibility Matrix.” Retrieved December 2022 from https://singlefamily.fanniemae.com/media/20786/display
Internal Revenue Service. “Topic No. 415 Renting Residential and Vacation Property.” Retrieved December 2022 from https://www.irs.gov/taxtopics/tc415