Can You Use Home Equity To Buy A Second Home?

For homeowners, home equity is an extremely valuable asset. So valuable, in fact, that it can be used for a variety of expenses. You can even use your home equity to purchase a second home, in full or in part. Depending on the size of your ownership stake, you can borrow large amounts through a home equity loan or a home equity line of credit (HELOC), well into the six figures. Even up to $1 million.

Can I use a HE loan or HELOC to buy a second home? If you have enough equity and meet the qualification requirements, absolutely you can. But perhaps a better question is: Should Would you use any of these home equity tools when buying a second home?

Using your home equity to buy a second home is often convenient and cost-effective, but it also carries certain risks. Learn how this financing option works, what are the pros, cons, and alternatives.

How to use your home equity to buy another home

If you want to use your home equity to buy a second home, you have a few options: The two most common are a home equity loan and a HELOC.

Although these two products have similarities (for example, they’re both second mortgages that require your home as collateral), they also have important differences. Here’s how they each work:

Mortgage

A home equity loan allows you to borrow a lump sum from the equity you’ve built up in your home. The amount you can borrow is based on how much equity you have in your home and its current fair market value.

For example, let’s say your home is worth $500,000 and you’ve accumulated $300,000 in equity (your mortgage balance is $200,000). Most lenders will let you tap up to 85 percent of that equity, which in this case would be $255,000. (To calculate how much you can borrow, check out Bankrate’s home equity calculator.)

With a home equity loan, you receive the full amount all at once and can use the funds however you like. For example, if you’re looking to buy a vacation home, you could use the funds for a down payment and closing costs. You then pay off your home equity loan in monthly installments at a fixed interest rate over a term of up to 30 years.

HELOC (Home Equity Loan)

A HELOC provides a revolving line of credit, like a credit card, so you can borrow money in small increments rather than receiving a lump sum. Like a home equity loan, a HELOC typically allows you to borrow up to 85% of your equity. However, a HELOC usually has a variable interest rate that can rise or fall based on current economic conditions.

During the initial draw period (the first 5 to 10 years of the HELOC), you can withdraw funds as needed and pay only the interest on the amount you borrowed. As you pay back some of the principal, your available credit increases and you can withdraw funds again. After the draw period, you enter a repayment period, usually 10 to 20 years, during which withdrawals are no longer allowed and you must pay back the principal of the HELOC plus any additional interest.

What are the pros and cons of using your home equity to buy another home?

Wondering whether you should leverage your equity to buy a second home? Weigh these pros and cons.

Tax benefits for home loans

If you use it as a second home, you may lose one of the fundamental benefits of a mortgage: being able to deduct the interest on the loan when paying your taxes.

“The IRS requires that in order to be deductible, the interest must be used to purchase, build, or substantially renovate the home that the loan is securing,” says Dennis Shirshkov, head of growth at real estate investing platform Awning.com. That means if you use your primary residence as collateral for a HE loan or HELOC and then use the funds to buy a beach bungalow, mountain cabin, or other different property, you won’t be able to take a tax deduction for the interest — you’re required to renovate the current home that you’re borrowing against.

Shirshkov says tax breaks may also be available for second home purchases. “Purchases of adjacent land or property can be considered part of this[home improvement]especially if you can demonstrate that such acquisitions enhance or complement the value or utility of your primary residence.” For example, you could use the equity in your home to acquire a wooded area behind your house, clear it and build a small guesthouse, or buy a neighboring house to connect it to yours.

Shirshkov recalls a case where a homeowner used a mortgage to purchase vacant land adjacent to their home “because the purchase would prevent potentially disruptive development on the property and preserve the look and value of the home,” he says. “The IRS recognized this as a substantial improvement to the home.”

Using home equity as a down payment

Given the realities of today’s real estate market, coming up with cash for a down payment is a major challenge for many potential buyers. According to Bankrate’s February Down Payment Survey, more than half of potential homebuyers say they can’t currently afford a down payment and fees because the cost of living is too high (51%) or their income is not enough (54%). These are the main reasons they’re putting off buying a home.

If you’re struggling to come up with a down payment, it might be worth considering tapping into your home equity, though not all lenders will let you use your home equity money towards your new home if you plan on financing the rest with a mortgage.

Matt Dunbar, senior vice president of the Southeast region at Churchill Mortgage, says there’s no general rule in the mortgage industry that prohibits down payments. But because a down payment is supposed to be an unconditional cash contribution from the buyer, it can be problematic when it’s money that must be paid back. “For lenders, the key when evaluating a scenario like this is to make sure the borrower’s debt-to-income ratio (DTI) accurately reflects all financial obligations, including any new debt arising from the HELOC,” he explains.

Essentially, lenders want to be sure they’re making, in Dunbar’s words, “an informed decision regarding the borrower’s financial capabilities.” Dunbar recommends financing and putting down home equity well before applying for a mortgage to give the funds time to ripen (and for the debt to show up on your credit report).

When choosing a lender, keep this in mind as policies vary from institution to institution. “Some savings banks and credit unions don’t allow this practice, but independent mortgage companies do allow you to use HELOC funds for a second home or investment property,” says Jay Gerbens, a Colorado Springs-based real estate investor and business development manager at Churchill Mortgage. “In fact, the disclosure section of a standard loan application asks if you’re borrowing any part of your down payment, so this practice is not uncommon.” Also, double-check the fine print in your mortgage or HELOC agreement to make sure you’re not prohibited from buying or investing in real estate.

Should I take out a mortgage to buy an investment property?

If you don’t plan on living in your new home, you could also use your equity to buy an investment property — a home that you can flip or rent to generate income. (Again, you’ll need to work with a lender that will let you put mortgage funds toward your down payment.) Let’s look at some of the pros and cons of doing so.

On the plus side, if you’ve built up a lot of equity, you can access a lot of money through a home equity loan, or HELOC, which is important when buying an investment property, which has stricter qualification standards than a second home and typically requires a down payment of 15 to 25 percent.

At the same time, financing an investment property with your own money carries risks. Ideally, your new property will provide you with a steady income (through rent or lease payments) that will allow you to pay off your mortgage or HELOC on time, but unfortunately, that’s not guaranteed.

Let’s say you renovate your new investment property with the intention of selling it at a profit. What happens if you can’t attract a suitable buyer? Or what if you put it on the rental market but struggle to find reliable tenants? In either case, you remain responsible for paying back the amount you borrowed. If you can’t, you could lose the property.

What to do instead of taking out a mortgage when buying a second property

While a home equity loan or HELOC is a popular financing tool these days, it’s not your only option. In fact, “just because you can doesn’t mean you should,” says Greg McBride, chief financial analyst at Bankrate. “You may have a lot of equity in your primary home, but borrowing from that equity to buy a second home is a costly proposition with many home equity interest rates now reaching double digits — high borrowing costs that put your primary home at risk in the event of a default.”

If you need to think twice before taking out a mortgage to buy another home, there are several alternatives to consider. Some options will finance a large part of the purchase cost, while others will cover the initial costs (down payment, administrative fees).

• New mortgage: “In most cases, people considering buying a second home are better off taking out a mortgage on the property they’re buying,” says McBride. Taking out a loan against your new property allows you to itemize deductions (up to the total mortgage debt limits that apply to all mortgages). Of course, you’ll need enough cash to cover a down payment.
• Retirement Savings: Taking out a loan from your 401(k) plan could help you put up to $50,000 toward buying a second home. Not all employers offer this option, but if you do, you can pay it off over five years (or less if you leave your job) without paying penalties or taxes.
• Personal Loans: With a personal loan, you can typically borrow up to $50,000. Some lenders will lend up to $100,000 to qualified applicants. However, personal loans tend to have higher interest rates than home equity loans. Also, most lenders won’t allow you to use an unsecured personal loan for items purchased with a mortgage. However, if you can make the deal with cash, a personal loan could help you cross the finish line.
• Cash-out refinance: When you do a cash-out refinance, you replace your current mortgage with a new, larger loan. The new loan includes your mortgage balance, plus some of the equity you’ve built up over the years, so you can immediately use it for any purpose.
• Reverse Mortgages: If you’re over 62 and have significant equity in your home, you can take out a reverse mortgage and exchange some of that equity for cash. Under this arrangement, you receive tax-free payments from the lender that you must repay when you move, sell your home, or die.
• Private Lending/Investment: You could also consider borrowing money from a peer-to-peer (P2P) lender to buy a home. Offered by individuals or groups of investors, P2P loans are usually unsecured and have a wide range of eligibility criteria, terms, and interest rates. Another option is a shared equity arrangement, in which an investment company provides a lump sum of funds in exchange for a share of the future (possibly appreciated) value of your primary home.
• Hard Money Loans: A hard money loan (also called a bridge loan) is a form of short-term borrowing often used by home flippers. Like a home equity loan, it is secured by the property involved, not the applicant’s credit score or personal financial situation. Funded by private lenders or investor groups, hard money loans have high interest rates and short repayment periods, often less than a year. As the synonym suggests, they are intended to “fill” a financing gap until other financing is found or the home is sold.
• Seller Financing: Owner financing is another alternative to taking out a mortgage to buy another home. In this arrangement, the homeowner or seller, rather than a bank or mortgage lender, provides some or all of the purchase financing to the buyer. The buyer repays the seller, with interest, according to a mutually agreed-upon schedule.

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Additional Reports Mia Taylor