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Buying a second property with equity
Here's how to buy a cottage or a second home, including how to finance it.
If you’ve already bought your first home and have acquired positive equity, congratulations! You’ve already built wealth, but that doesn’t mean you must stop there. Now, you might be considering buying a second property with equity built up in your first property. Many Canadians choose to do this for investment or enjoyment purposes. As long as you aren’t overextending your finances, purchasing another property with equity is an optimal strategy to build more wealth.
What is equity?
Equity is the portion of an investment you own after considering obligations that exist against the investment. In terms of home equity, the amount is usually the current market value of your property less the outstanding mortgage balance. However, there could be other obligations against your home to consider, such as liens or legal costs. For example, if your home is valued at $750,000 and you owe $500,000 on your mortgage, you have $250,000 in equity.
Equity increases in two ways:
- You build equity by making regular mortgage payments toward both the principal amount and interest charges. The more you pay down the principal of your mortgage, the more equity you create.
- You also build equity when your home rises in value. If you paid $650,000 for your home and it’s currently valued at $700,000, you would have accrued $50,000 in equity through capital growth.
Why would someone be interested in buying a second home?
Using equity to buy a second home is done for a variety of purposes. Possible uses for a second property include:
- Rental property
- Investment property
- Vacation home, for example, a cottage or snowbird property
How can I use the equity in my home?
Home equity is considered an asset in the eyes of lenders. They will extend financing to a borrower in exchange for home equity as collateral. Borrowers can also withdraw home equity through refinancing.
Oftentimes, this type of lending is used to finance the down payment portion of a second property purchase. With that being said, home equity based financing can be used for other purposes as well, such as home renovations, debt consolidation or costs of new home ownership.
There are two methods that allow a borrower to withdraw equity from their current property:
1. Mortgage refinancing
Mortgage refinancing is the process of replacing an existing mortgage with a new mortgage. You can refinance using your existing lender or a new one. Typically, borrowers choose to refinance for better interest rates or more favourable terms. Mortgage holders can also refinance to withdraw positive equity in the form of cash. This cash can be used as a down payment for a second property purchase or any other purpose.
The main drawback to refinancing is the principal amount of your mortgage will increase. In addition, the total interest you pay over the life of the mortgage will increase.
2. Home equity line of credit (HELOC)
A home equity line of credit, or HELOC for short, is a line of credit that uses positive equity in your home as collateral. A HELOC is revolving credit which means you can borrow as much or as little as you want, so long as you don’t exceed the approved credit limit. Once you have an outstanding balance, you can pay it down whenever you want. The only amounts you’re required to pay are the interest payments. You can obtain a HELOC by tying it to your existing mortgage or you can apply for an entirely new HELOC separate from your mortgage.
HELOCs are very flexible and never disappear the way a loan does. They’re also useful in emergencies or when cash is tight. Although, it can be easy to over borrow with a HELOC because it’s so accessible. Be sure that you’re not overleveraging your finances.
In Canada, you can borrow up to 65% of the value of your home with a HELOC. However, any outstanding mortgage balance plus your HELOC cannot equal more than 80% of your home’s value.
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How can I boost my borrowing power?
It’s unwise to borrow more than you can comfortably afford to pay back – especially since no matter which route you take, both your primary home and your second investment property can be lost if you fail to make repayments. 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. 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 towards paying down the principal of your mortgage. By doing this, you’ll build up additional equity you can borrow against – and pay less interest on your balance.
How to turn your home into a rental property
Many people are motivated to purchase a second property to earn rental income. There are two main things to consider before proceeding:
1. Renting with a mortgage
Some mortgage agreements state that you cannot rent out the financed property. Before renting out a mortgaged property, be sure to read the fine print of your agreement to determine if renting is possible. There may also be stipulations that require you to wait for a certain period of time to pass before renting too.
If renting isn’t allowed under your current mortgage agreement, don’t worry, the road doesn’t end here. You can refinance your mortgage to get conditions that allow you to rent out the mortgaged property.
2. Can you afford a second property?
Before you invest in a property, make sure you do your research on income versus expenses. Determine how much rental income you’ll be able to generate versus the expenses of managing the property and paying off your new mortgage.
If your forecasted income and expenses are reasonable, using your equity to build a property portfolio can be a financially savvy decision. Just be sure you aren’t overextending your finances before making the final decision.
Building a safety net
The most important way you can mitigate the risks involved in borrowing equity from your primary residence for an investment property is to build in a cash buffer, or a safety net.
A cash buffer helps you cover periods when the rental income you receive from your investment property fluctuates. This could be due to untenanted periods or financial hardship on the part of your tenants.
It can also serve as an emergency fund in the event of unexpected repairs. While some repairs can be claimed on insurance, a cash buffer will help you get repairs underway while you wait for your claim to be processed, or can help you cover the entire cost if it’s not covered under your insurance.
In addition, the buffer will serve as a safeguard in the event of a rise in your expenses. If you have a variable rate mortgage, your interest 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.
Using your equity for buying a second home can be a great way to build wealth. But before you take on a new mortgage, consider your current financial situation and ensure you’ve budgeted wisely and have enough cash on hand to cover anything you might not have budgeted for. You’ll also want to keep in mind that you’re risking both your primary home and your investment property by refinancing or taking on a HELOC.
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