Using Home Equity for a Down Payment on a Second Home
Once you’ve built up a good chunk of equity in your home, you may think about using it to buy another property. But before you do, it’s important to understand the options that are available, as well as the benefits and risks of using your home equity for a down payment on a second home.
Key takeaways
- Some ways to tap your home’s equity include a home equity line of credit (HELOC) and a home equity loan.
- The amount you can borrow depends on various factors, including your loan-to-value ratio and credit score.
- You’ll need to complete an application and pay closing costs to get a HELOC or home equity loan.
Options for using home equity as a down payment for a second home
Converting your home equity to cash can help you afford the down payment on a second home. Here are some of your options:
HELOC
You can use the funds from a HELOC toward the down payment on a second home. A HELOC is a revolving line of credit. You can use and reuse the credit line up to your credit limit, and then make payments based on the amount of credit you use, plus interest.
Most HELOC lenders offer an interest-only option, which allows you to make only interest payments for a set period of time. This option may come in handy if you need to keep your payments low while making improvements to the home you’re buying. Keep in mind, though, that while your initial payments will be lower, the total amount of interest you pay will be higher.
Home equity loan
With a home equity loan, you receive a lump sum of money upfront and repay the loan in fixed monthly installments over a set term. Lenders set home equity loan rates based on various factors, including your credit score and debt-to-income ratio. If you prefer the stability of a fixed-rate monthly payment, you may want to consider using a home equity loan to buy a second home.
Cash-out refinance
A cash-out refinance allows you to pay off your current mortgage and borrow more than you currently owe. You can then use the extra cash to buy a second home, and it may be easier to qualify for than other home equity products. For example, an FHA cash-out refinance allows you to borrow up to 80% of your home’s value with a credit score as low as 500, compared to the 620 minimum usually required on a home equity loan or HELOC.
Still unsure which is right for you? Read our comparison of cash-out refinances vs home equity loans vs HELOCs.
How to use home equity as a down payment for a second home
One of the first things to consider is how you plan to use the second home. If you plan to use the home as an investment property and collect rent from a tenant, then most lenders will require at least 20% down. The minimum down payment for a second home is 10%.
Once you know the down payment you need, here’s what to do next:
1. Determine how much you can borrow
You’re typically limited to borrowing 85% of your available equity when taking out a home equity loan. Lenders set your maximum home equity loan amount based on your home’s loan-to-value (LTV) ratio. LTV is the percentage of your home’s value that’s financed by the loan for which you apply.
Here’s a quick example of how to calculate LTV:
If your home is worth $400,000, for example, and you owe $300,000 on your first mortgage, you have $100,000 in equity. Here are the steps you’d take to calculate your maximum home equity or HELOC amount, assuming the lender’s maximum LTV ratio is 85%.
Multiply your home’s value by 85% (0.85) x $400,000 = $340,000
Subtract your current loan balance from that amount: ($300,000)
Maximum home equity loan/HELOC amount: $40,000
Note that this example is for educational purposes only. Your actual loan amount will depend on various factors, including your income and credit score.
Learn more about how much you could borrow using a home equity loan calculator.
High-LTV home equity loans
Some lenders offer high-LTV home equity loans that allow you to borrow up to 100% of your home’s value. A word of caution, though: If you need to sell your home due to a sudden job transfer or an emergency, you could end up paying out of pocket at closing if your equity is tied up in the purchase of another home.
2. Budget for the cost of using home equity to purchase a new home
Home equity loan closing costs typically range between 2% and 5% of the loan, although costs vary from lender to lender. Your local bank or credit union may offer a special closing cost or interest rate discount on a home equity loan if you have other accounts (such as checking and savings) with it.
You can also expect to shell out between 2% and 5% of your HELOC amount for closing costs. Further, you’ll want to review your budget to ensure you can afford the additional monthly payment.
3. Consider additional expenses
Closing costs aren’t the only expenses involved in buying a second home. Additional expenses that come with owning a second home include:
→ Property taxes
→ Homeowners insurance
→ Landlord insurance (if you plan to rent out the home)
→ Utility expenses (water, electricity, gas, etc.)
→ Maintenance expenses
→ Homeowners association fees (if the home is located in an HOA community)
4. Compare lenders
It’s a good idea to compare multiple lenders to find the best option for your needs. When researching lenders, factors to consider are interest rates, fees and repayment periods. If you need cash quickly, you may want to consider HELOC lenders that specialize in fast closings.
5. Complete an application
Whether you choose a home equity loan, HELOC or another kind of financing option, you’ll need to fill out an application. The application process is similar to applying for a first mortgage — a lender will assess your financial situation, including your income and debt-to-income ratio.
Pros and cons of using home equity to buy a second home
| Pros | Cons | |||
|---|---|---|---|---|
You’ll leave your cash reserves alone You can make 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 You’ll have a longer repayment period than you would with other types of financing, such as personal loans | Your interest charges aren’t tax-deductible You may have two mortgage payments on your current home You’ll have to pay additional fees You’ll have a variable rate with a HELOC You could lose your home if you default on a home equity loan or HELOC You could end up with an underwater mortgage if your home’s value drops You must repay your home equity loan when you sell your home |
Is using home equity to purchase a new home a good idea?
It may make sense to use home equity to buy a second home if:
- You have plenty of extra equity in your home or don’t owe anything on it
- You plan to pay off the mortgage with extra earnings or cash windfalls in the future
- You have stable income and the resources to make multiple mortgage payments
- You’ll make enough rental income to offset the new payment
Can you afford three mortgage payments?
Before you make a final decision on using home equity to buy a second home, make sure your budget can potentially handle three monthly mortgage payments. Remember, you’ll make payments on:
→ The mortgage on your main home
→ The home equity loan or HELOC on your main home
→ The mortgage on your second home or investment property
If you’re buying a second home, find out how much rental income you could earn in case you need extra funds to cover a job loss or sudden reduction in your earnings. Don’t forget about the tax implications of renting out a property: If a tenant lives there and pays rent for more than 14 days each year, you should have a tax professional give you guidance.
Other ways to cover a down payment for a second home
Take out a 401(k) loan
Some 401(k) loan programs allow you to borrow against your current 401(k), even if you’re not buying a primary residence. The maximum you could take out is 50% of your vested account balance or $50,000, whichever is less. Just be careful: The money you borrow won’t be working for you in the market.
Set up a long-term savings plan
If you prefer not to leverage your home equity for a down payment on a second home, try the longer-term approach of saving for a house over time. You can reach your savings goal faster by picking up a side hustle or downsizing your home.
Personal loan
Another option is to use a personal loan for a down payment on a second home. The main drawbacks of this option are that personal loans have higher interest rates than home equity products and typically shorter repayment periods. In addition, many lenders won’t accept an unsecured personal loan as a source of down payment funds.
Reverse mortgage
Borrowers age 62 or older may be able to use their equity for a down payment on a second home with a reverse mortgage. With a reverse mortgage, you’ll receive payments based on your home’s equity, and you won’t need to repay the loan until you die or sell your home. Keep in mind, however, that with a reverse mortgage, your loan balance goes up, not down, over time.