If you’re a current homeowner looking to invest in another property, you can leverage your existing home to build your property portfolio. But you could risk losing one — or both — homes if you lack financial stability.
Why do people buy a second home?
Homeowners decide to purchase a second home for a variety of reasons. Some of the most common are:
- Extra income. By generating passive income from rent payments, it’s possible to earn extra cash from your second property.
- Vacation home. If you’re able to carry the mortgage on your own, you could have somewhere available to relax and unwind.
- Property flip. Get your work gloves on and renovate the home to resell at a profit.
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Ways to finance a second home
There’s no shortage of options for making your dream of owning a second home a reality. Some of the more common methods include:
Home equity loan or HELOC
Unlock funds tied up in your house through a home equity line of credit (HELOC). This is a separate home loan that extends you an amount of credit based on the equity in your property. Lenders typically limit a HELOC to up to 80% of your home’s value that you can draw from on an as-needed basis.
You can use as much of the credit limit as you like, and you’ll only pay interest on the amount you use. This can be a tax-effective strategy for investing in property because it maximizes your tax-deductible debt by allowing you to make interest-only payments.
Refinance to replace your current home loan with a new mortgage in a higher amount that you can draw from. You’ll get a new home loan and have a portion of your home equity available in a lump sum. It can be used for anything from renovations and paying off debt to a down payment on a new home.
Take out a lien against the portion of your mortgage that you’ve paid off. Similar to a HELOC, you can use extra money from a second mortgage for almost anything — including purchasing a second property. On the downside, the lien gives your lender the right to possess the property if you default on payment.
If you have a healthy credit score, a strong debt-to-income ratio and significant income and assets backing you up, a conventional loan is an option.
Expect a down payment of between 20% and up to 35% for some lenders, plus a slightly higher interest rate from your principal residence. Also, if you’re banking on potentially renting out the second home to meet your mortgage obligations, many lenders won’t accept rental income as a solid qualification for a second home loan.
What is equity?
Equity is the difference between your home’s value and the amount you owe on your mortgage. For instance, if your home is valued at $300,000 and you owe $250,000 on the loan, you have $50,000 in equity.
Equity increases in two ways. First, you build equity by making your regular principal and interest repayments. The more you pay down the principal of your home loan, the more equity you create. The second way equity accrues is through your home rising in value.
What to consider before purchasing a second home
It’s unwise to borrow more than you can comfortably afford to repay. But if you’ve budgeted well and have a clear idea of the amount of debt you can handle, there are a few steps you can take to boost your borrowing power.
- Minimize your existing debt to boost your borrowing power. Consider whether you can afford to take some time to pay down any existing credit cards, personal loans or car loans before you apply for a new mortgage.
- Make extra payments on your existing mortgage. Any amount you pay above your minimum payment will go toward paying down the principal of your loan. By doing this, you’ll build up additional equity you can borrow against.
- Know beforehand how much rental income you’ll be able earn. Conduct thorough research before deciding to rent the second home in order to meet your mortgage payments so you don’t default.
Regardless of which option you choose, make sure you won’t be over-extending yourself before you decide to invest.
What risks are involved with buying a second home?
As with any investment, there are key risks for you to consider, such as:
- Emergency repairs. Need to replace a furnace or roof? Many emergency repairs are not covered under homeowner’s insurance so, you’ll be out of pocket for some surprise expenses.
- Risk of losing both homes if you purchase using your current home’s equity. If you use a HELOC or refinance your existing mortgage to purchase a second home and then default on its repayments, both your primary home and your second home run the risk of foreclosure.
- Unexpected life events. If you lose your job, experience a disability or are unable to rent out the property as you’d envisioned, unforeseen events can leave you unable to carry a second home.
- Fluctuating or rising expenses. Did your car insurance suddenly go up? Or has your son unexpectedly decided he wants to become a doctor? Life can throw you those kinds of curveballs that can suddenly change your monthly obligations.
Build in a safety net
Mitigate the risk involved in borrowing for an investment property by building up a cash buffer. Extra cash helps you cover periods if the rental income you receive from your investment property falls short — perhaps you have untenanted periods or your tenants experience financial hardship.
In addition, if you have a variable-rate home loan, your rate and monthly payments could increase at any time. A cash buffer helps alleviate the pressure from rising expenses and gives you time to respond, either through better budgeting or increasing your rental income.
A second property investment can be a great way to build wealth. But before you invest in a new mortgage, consider your current financial circumstances and have enough cash on hand to cover any rainy days — and be sure you’ve thoroughly budgeted and researched all costs and expenses so you know you’re covered.
Frequently asked questions
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