Home equity is useful when you’re looking to buy another house. There are several ways to go about it, such as a home equity loan, home equity line of credit (HELOC), cash-out refinance or a reverse mortgage.
How to use a home equity loan to buy a second home
A home equity loan is when you borrow against the equity in your current home. This method is often called a second mortgage, and is a pretty common way for homeowners to get a second home while keeping their current home.
Your equity is equal to the difference between your mortgage balance and your home’s current value. Let’s say you have a house valued at $200,000 and owe $150,000 — that’s approximately $50,000 in equity that you can use to get another home.
The amount of equity you’ve accumulated determines the amount you can borrow for a home equity loan. Using our example, if you have $50,000 in equity, a home equity loan usually lets you borrow 80% to 85% of your equity, or around $40,000 in lump sum, which could be used to fund a down payment on a second home.
Typically, the lender requirements for a home equity loan are:
- At least 15% to 20% equity, depending on the lender.
- A debt to income (DTI) ratio between below 43%.
- Ability to pay in terms of creditworthiness and income.
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Consider 3 other types of home equity financing
You have other options for using your equity to get a second house or investment property. Each option varies in lender requirements and how much equity you need to qualify. Explore the pros and cons of each to help you determine which option fits your situation the best.
Home equity line of credit (HELOC)
A home equity line of credit (HELOC) is similar to a home equity loan, but there are some notable differences.
A HELOC is a line credit, or revolving credit, like a credit card. With a HELOC, your borrowing limit is defined by how much equity you have in your home. The house is also the loan’s collateral. Typically, you can borrow up to 80% of your home’s equity if you qualify.
However, you don’t have to max out the line of credit — you can borrow only what you need. You borrow in a set period of time, called a draw period.
After the draw period, the HELOC payments are amortized and you make the payments over time. You can draw the amount you need to make a down payment on a second home.
Common eligibility requirements for a HELOC include:
- At least 15% to 20% equity.
- Credit score at or above 620.
- Acceptable DTI and loan-to-value (LTV) ratios, vary by lender.
A cash-out refinance is when you take on a new loan for your home that pays off your old one, and you get to pocket the equity. In a sense, you’re replacing your old loan with a new one and cashing out the equity that you’ve earned over the course of your mortgage.
The cashed out equity is given to you in a lump sum, and could be used to fund a down payment on a second home or investment property. However, if you go through with a cash-out refi, then know it’s unlikely that you’ll be able to cash out all your equity; it’s usually around 70% to 80% of it.
Typical lender requirements for a cash-out refinance include:
- At least 20% equity.
- An appraisal of your home.
- Credit score at or above 620.
- Acceptable DTI and LTV ratios.
There are four types of reverse mortgages, but in a nutshell, you receive payments from your lender by relinquishing the equity in your home in exchange for payments, either in the form of lump sums, line of credit or monthly payments, or a combination of the three.
This option is for homeowners over 62, those who own their property or have it nearly paid off, and the home you use for a reverse mortgage must be the primary residence.
For many homeowners, a reverse mortgage is used to supplement income, cover medical expenses, or used to buy a second home — often a vacation home.
There is a reverse mortgage type called a Home Equity Conversion Mortgage for Purchase, or HECM for Purchase. This loan allows you to buy another home with a down payment between 45% to 62% of the sale price, depending on your age.
Common eligibility requirements for a reverse mortgage include:
- Youngest homeowner is at least 62.
- Home is paid off or nearly paid off.
- Home is the primary residence.
- No delinquencies on federal debt.
How soon after buying a house can I use home equity to buy a new home?
Generally, lenders prefer homeowners to have their loan for at least six months to a year before cashing out equity. And technically, you could get a home equity loan immediately after purchase if you made a 15% to 20% down payment because by default, you’re already meeting equity requirements.
For a HELOC, you can get one as soon as a month after your purchase. However, applying for any of those options after your home purchase could still lead to a denial, since a good payment history on your current mortgage is likely to be considered.
Can I use home equity to buy an investment property?
Yes, you can use home equity to buy an investment property. You can use your home’s equity to fund the down payment or use the funds to cover other investment property expenses. You may be able to use a home equity loan, HELOC, cash-out refinance or reverse mortgage to help fund the purchase of an investment property if you have enough equity and a low DTI ratio.
Financing investment properties are risky, so lenders tend to have high down payment requirements — often at least 25%. Home equity financing can certainly help you meet that requirement, but not without risk.
By using home equity financing, you’re putting your home on the chopping block if you can’t repay the loan. Additionally, you’re reducing the hard-earned equity in your home, so only use home equity financing to fund another property purchase if you’re sure you can afford it.
Financing a second home vs. investment property
When you’re buying another house, you must tell the lender what you plan on using the house for: primary residence, second home/vacation house, or investment property. Using home equity to get a second home is different than buying an investment property.
Second homes have occupancy requirements: You must occupy the second home for more than 14 days every year. Investment properties don’t have occupancy requirements, and can be rented out all year long.
Generally, second home loans have stricter requirements compared to primary home loans, especially when it comes to down payments, creditworthiness, and DTI and LTV ratios. Investment properties can also be difficult to qualify for, often requiring down payments at or above 25% and high credit scores — and you may be saddled with a higher interest rate and more fees during the lending process than a primary home loan.
Similar to primary residences, though, second homes can qualify for tax deductions on interest payments. With investment properties, there may be more tax deduction opportunities, such as deducting interest, insurance, property taxes, maintenance and even damages from tenants.
Be sure to talk with your lender about requirements, and your tax preparer on tax implications if you buy a second home or investment property.
Compare interest rates for home equity loans, HELOCs and cash-out refinancing
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If you selected a home equity loan or HELOC, enter your ZIP code, credit score and information about your current home to see your personalized rates.
In the Cash-Out Refinance tab, select Refinance and enter your ZIP code, credit score and other property details to see what you might qualify for.
Advantages of using home equity
A few advantages in using home equity to buy another home include:
- Down payment — Instead of having to shell out thousands of dollars out of pocket or saving for years, using your home equity could increase your down payment amount and get you into a second home faster.
- Lower rates — Home equity loans specifically tend to have lower rates than other loans, such as personal loans (but usually not lower than traditional mortgages).
- HELOCs offer flexibility — With a HELOC, you can borrow as needed, which can be helpful if you’re not sure how much you want or need to borrow for your second home. And you only pay interest on what you draw.
- Investment income — If you use your current home’s equity to purchase an investment property, the income from that property can help cover your incurred debt. In a sense, it could pay for itself.
Disadvantages to using home equity
While there can be many benefits to using your home’s equity for another home purchase, there are a few downsides to keep in mind:
- Less equity, more debt — That hard-earned equity would turn into new debt, and it could make you vulnerable to the ever-shifting housing market. If your home’s value depreciates, that could leave you in a negative equity position.
- May be spread thin — If you use your home’s equity to buy another house, now you have two homes to cover under insurance, higher property taxes and double all the costs associated with owning a home. And don’t forget about the additional home maintenance you’ll have to manage.
- Maybe three mortgages — If you take out a home equity loan, often called a second mortgage, that would mean you have your original home’s mortgage, the second mortgage plus the third home’s mortgage payments.
- Home equity loan may not be tax-deductible — Interest on home loans and home equity loans can be tax-deductible. However, home equity loan interest is tax-deductible if you use the money to improve the home — not buy another home.
Of course, you’re not required to use up your home’s equity to get into another home. If your home or situation doesn’t meet typical home equity requirements, you may need to save up for it.
It’s been said again and again from financial experts — saving up for a down payment is one of the better alternatives to using home equity or taking on more debt.
For many, having $20,000 or even $100,000 in cash for a down payment seems unattainable. However, taking the time to save can be worth it, especially if you don’t want to be stuck with more debt or worry about interest. Check out our money management tips if this is the route you want to take.
Most lenders don’t accept personal loans as a down payment
Unfortunately, most lenders won’t take funds from a personal loan for a down payment. This includes conventional and FHA loans.
And taking on a personal loan means increasing your DTI ratio as well, so it could knock you out of the running for mortgage approval unless you have a fantastic credit score, high income and a low DTI ratio to begin with.
Your home’s equity can be very useful if you’re looking to get into a second home, or get your hands on a (hopefully) profitable investment property. And with four solid ways to utilize that hard-earned equity, you’ve got a decent spread of options.
Compare interest rates for home equity loans, HELOCs and cash-out refinancing.