How You Can Use Home Equity to Buy Another House | Mortgages and Advice

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Most of us are happy to own just one home. But others have an eye on buying a second home. Using the equity from the first home is one way to make that dream a reality.

Many borrowers use equity to purchase a vacation home, rental property or second home. But before you do, it’s important to weigh the pros and cons.

What Is a Home Equity Loan?

A home equity loan lets you borrow against the equity in your home. You may use the cash to pay off debt, fund a home renovation project or for another purpose.

This type of loan typically comes with a fixed rate. You get the money as a lump sum and pay back the loan over time.

A home equity loan can be an attractive option for folks who need to borrow. “Compared to other loan types, home equity loans or lines of credit frequently have lower interest rates,” says Jim Shagawat, a certified financial planner and partner advisor at AdvicePeriod in Paramus, New Jersey.

Rates usually are much lower than those associated with credit cards, for example.

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However, a home equity loan comes with a major risk: Your home typically serves as collateral for the loan, putting it at risk of foreclosure if you don’t keep up with the payments.

“If you’re unable to meet mortgage payments on the second home, you run the risk of losing both properties,” says Randy Bruns, founder of Model Wealth in Naperville, Illinois, and a senior financial planner with the firm.

Many factors determine how much money you can borrow via a home equity loan. They include your:

  • Income. 
  • Credit history.
  • Home’s market value.

Even if all of these things are working in your favor, lenders will typically restrict you from borrowing more than 80% of the equity in your home, according to the Federal Trade Commission.

Still, some lenders may agree to lend you more – even up to 100% of your home equity.

An initial payment made when the home is bought.

The amount of time you have to repay the mortgage.

Payment Details

Monthly Payment Breakdown

Should You Choose a Home Equity Loan or a HELOC? 

A home equity loan and a home equity line of credit both give you access to money by allowing you to borrow against the equity in your home. However, there are key differences.

With a home equity loan, you typically get a lump sum and borrow at a fixed interest rate.

In contrast, a home equity line of credit lets you borrow and repay multiple times, much as you would with a credit card. The interest rate is typically adjustable.

The right choice between these two types of borrowing tools will depend upon your goals and circumstances.

Can You Use Equity to Buy Another Home?

Many people use the equity in their home to buy a second home for their own use or as an investment property to generate rental income.

Is Cash-Out Refinance a Good Option?

Cash-out refinancing is another way you can tap the equity in your existing home to help purchase a second property. With a cash-out refinance, you take out a new mortgage for an amount higher than what you owe on your existing mortgage.

This loan effectively pays off your existing mortgage and allows you to receive cash for a portion of the equity you have built, which could then be put toward the purchase of a second property.

Keep in mind that a cash-out refinance effectively means you are starting over with your mortgage. With many mortgages, there are also limits on how much equity you can cash out – usually 80% of the home’s appraised value. You’ll also want to consider any fees and closing costs involved in these transactions to be sure it’s worth doing.

Pros and Cons of Using Equity to Purchase Another Home

Some pros of using home equity to purchase a second home include:

  • The process may be more streamlined. Tapping equity to purchase a second home may make the purchase process a little easier. “One of the biggest benefits of using existing home equity to purchase another home is avoiding the underwriting of a new mortgage,” Bruns says.
  • You can use the money for your down payment. Using a home equity loan for a down payment on a second home can reduce the amount you need to borrow on a mortgage, potentially lowering your costs.
  • The interest rate might be lower. You might save money in interest costs by using a home equity loan or home equity line of credit versus other forms of borrowing, such as a personal loan. Fees and closing costs might also be lower. 
  • You might build additional wealth. If you use home equity to purchase a second home, it could help you build wealth over the long haul. This is particularly true if tapping your home equity helps you secure an income property that generates rental income – and appreciates in value – for years to come. 

Despite these advantages, using home equity also has some disadvantages, such as:

  • You could lose your primary home if you don’t repay your debt. This is the biggest risk of using equity to purchase another home. Your primary home stands as collateral when you use home equity to borrow. If you fail to make the payments, the lender can step in and seize your home through foreclosure. 
  • You could also lose your second home. If you cannot pay your home equity obligations, you could also lose your second home to foreclosure. 
  • Home equity payments may no longer be tax-deductible. In 2018, sweeping changes were made to the federal tax code. In the process, the rules changed in regard to the ability to deduct home equity interest payments from tax returns. The picture remains a bit cloudy, but it is generally agreed that unless you use home equity specifically to improve a property, the interest on the loan is likely not tax-deductible. 

Can You Use Equity for an Investment Property?

Many people use the equity in one property to buy an investment property. In fact, it is not uncommon for investors to repeat this process and add several income properties to their portfolio by using equity to help finance the purchases.

Pros and Cons of Using Home Equity to Buy an Investment Property

The pros and cons of using home equity to buy an investment property are pretty much the same as the pros and cons of using it to purchase another home. Make sure you read that list carefully before taking the plunge.

The bottom line is that home equity is often a convenient way to fund a down payment on an investment property. But using home equity in this way puts your properties at risk if you are unable to make your payments. In a worst-case scenario, you could lose one or more of the properties to foreclosure.

Alternatives to Using Home Equity to Buy Another House

While home equity can be a great source of cash when buying another house, it is not your only option.

“Instead of using your home equity to purchase a second home for investment purposes, you can use money from investment accounts or other assets,” Shagawat says.

Other alternatives to using home equity include:

  • Hard money loan. Borrowers may use a hard money loan to purchase an investment property, particularly if they are having trouble securing other types of financing. Private companies typically offer these loans, which often come with high interest rates. 
  • Personal loans. These types of loans are not secured by collateral, which means they often have higher interest rates than those associated with home equity borrowing. Your monthly payment might be higher and you generally need excellent credit to qualify. 
  • Seller financing. In this type of arrangement, the buyer of a property pays the seller in installments instead of using a mortgage. Fewer regulations pertain to these agreements, which can put the buyer at more risk. In addition, interest rates are higher and a larger down payment might be required. 

Other potential sources of money for a down payment include loans from family members, peer-to-peer lending and self-directed IRAs.

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