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Using Home Equity for a Down Payment on a Second Home
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Once you build a significant amount of equity in your home, you can tap it for virtually any purpose, including another real estate purchase. But first, it’s necessary to highlight the benefits and risks of using home equity for a down payment on a second home.
How to use home equity as a down payment for a second home
In order to qualify to buy a second home, you’ll need at least a 10% down payment. If you plan to strictly use the home as an investment property, the minimum down payment required is usually 15%.
Two common ways of using home equity for a down payment on a second home are to borrow:
A home equity loan is a lump sum of money paid to you upfront. You’d pay it back in fixed monthly installments over a set repayment term. On the other hand, a HELOC is a revolving line of credit. You’re able to use and reuse the credit line — so long as you don’t exceed your credit limit — and only make payments based on the amount of credit you use, plus interest.
How much can you borrow?
You’re typically limited to borrowing 85% of your available equity when taking out a home equity loan, according to the Federal Trade Commission (FTC). Some lenders offer high-LTV home equity loans, however. LTV stands for loan-to-value ratio, which is the percentage of your home’s value that is financed by home loans.
If your home is worth $300,000, for example, and you owe $200,000 on your first mortgage, you have $100,000 in equity. In many cases, you’d only be able to borrow up to $85,000 of that equity.
HELOC borrowing requirements differ slightly from those for home equity loans. Lenders usually allow you to borrow up to 85% of your home’s value, minus your outstanding first mortgage balance, according to the FTC. Using the above example, the maximum amount you might be permitted to borrow is $55,000.
Pros and cons of using home equity to buy second home
| You can retain more cash reserves for emergencies and other goals
You may have access to a larger down payment
You’ll get a fixed rate with a home equity loan
You can repay and reuse your credit line with a HELOC
| Your home will be used as collateral, putting you at risk of foreclosure
Your interest costs aren’t tax-deductible
You’ll have to pay closing costs to borrow against your equity
You’ll have a variable interest rate with a HELOC
What are the costs of using home equity to purchase a new home?
Similar to taking out a first mortgage, you’ll pay closing costs when tapping your home equity. Home equity loan closing costs range from 2% to 5% of your loan amount.
HELOC closing costs may be lower than what you’d expect on a home equity loan, depending on the lender. Still, HELOC lenders may charge ongoing costs, such as an annual fee and a transaction fee each time you borrow against the credit line, the FTC notes.
Home equity loans tend to have higher interest rates than HELOCs — that’s because HELOC rates are usually variable. With a home equity loan, you’re opting for the stability of a fixed rate over one that fluctuates, which means your lender charges more.
Can you really afford three mortgages?
If you’re planning on using home equity for a down payment on a second home — and don’t own your primary residence free and clear — you’ll jump from one mortgage to three:
- The first mortgage on your main home
- The second mortgage (home equity loan or HELOC) on your main home
- The first mortgage on your second home
Can your budget withstand these additional obligations?
Before making a decision, take all costs into consideration. The last thing you’d want is a second home to financially devastate your family and put you at risk of losing your main home to foreclosure.
Your second home may double as a rental property if you need to bring in extra income to cover what it costs to maintain it. There are tax implications for doing so, however. You must report rental income on your tax returns if your second home is used as an investment property for more than 14 days each year. Consult a tax professional for more guidance.
Other ways to cover a down payment for a second home
You can use a cash-out refinance to buy a second home. This type of refinance allows you to take out a new mortgage worth more than your existing home loan. You’ll pay off the first mortgage and pocket the rest in cash to use for your second home’s down payment.
If you’re not financially ready to cover a down payment for a second home, you could first try house hacking a multifamily property that serves as your primary residence. For example, if you borrow a home loan backed by the Federal Housing Administration (FHA) to buy a two- to four-unit property, you’d only need a 3.5% down payment. You must live in one of those units full time, but you can rent out the other units and earn extra income.
Whether you can’t or would rather not leverage your home equity for a down payment on a second home, you could take the longer-term approach of saving down payment funds over time. Expedite the process by picking up a side hustle or downsizing your home.