Using Home Equity for a Down Payment on a Second Home
Once you’ve built up a big chunk of equity in your home, you may think about tapping it to buy another property. Before you do, you should know 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
You’ll first need to determine how you intend to use the home in order to qualify to buy a second home. A second home is a residence that you occupy for a portion of the year, such as a beach home or cabin.
If you plan to use the home as an investment property and collect rent from a tenant living in the home, then lenders consider it an investment property. The minimum down payment for a second home is 10%, while most lenders require at least 20% down if you’re buying an investment property.
Once you know the minimum down payment, you’ll need to decide what type of loan you want to take out to convert your home equity to cash. There are typically two options to choose from: a home equity loan and a home equity line of credit (HELOC).
Choose a home equity loan to buy another house
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. If you prefer the stability of a fixed-rate monthly payment, you might consider a home equity loan to buy another house.
Use a HELOC to buy 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 would only make payments based on the amount of credit you use, plus interest.
Most HELOC lenders offer an interest-only option, which allows you to just pay the interest owed. This option may come in handy if you need the funds to keep your payment as low as possible while making improvements to the home you’re buying.
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 you apply for.
Here’s a quick example of how LTV is calculated:
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
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.
Budget for the cost of using home equity to purchase a new home
You’ll typically pay between 2% and 5% toward closing costs for a home equity loan, though the 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 (like checking and savings) with them.
You can also expect to shell out between 2% and 5% of your HELOC amount for closing costs. However, you may have to pay ongoing annual membership and maintenance fees that aren’t charged on home equity loans.
Pros and cons of using home equity to buy a second home
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
Your interest charges aren’t tax-deductible
You’ll have two mortgage payments on your current home
You’ll have a variable rate with a HELOC
You could lose your home if you default on a home equity loan or HELOC
Is using home equity to purchase a new home a good idea?
It may make sense to use home equity to buy another 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 three 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 first mortgage on your main home
- The home equity loan or HELOC on your main home
- The first 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 earning. Don’t forget about the tax implications of renting a property: If a tenant lives there and pays rent 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
You can pay off your current mortgage and borrow more than you currently owe with a cash-out refinance. The extra cash can be used to buy a second home, and 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.
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. 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 speed up your savings stockpile by picking up a side hustle or downsizing your home.