How to Use Home Equity to Buy a Second Property
LS
Summary:
If you have a lot of equity in your primary residence, you might be able to take out a home equity loan or otherwise access that money for more useful and profitable purposes. For example, you can use the home equity loan to buy an investment property or perhaps a second home or vacation property. Other possibilities to leverage that home equity are to get a cash-out refinance, home equity line of credit, or home equity conversion mortgage.
Once you have built up a lot of equity in your house, you might be wondering exactly what you can do with that money. It’s yours and it’s just sitting there after all. There are a lot of ways to get to that cash — such as a home equity loan. These loans are often disbursed as lump sum payments, which you’re free to use however you want.
Many people choose to use the cash to purchase an investment property, which (frankly) is a much better idea than, say, using the windfall to take a trip around the world. But keep in mind that taking out a second mortgage on your house is not without its risks. Let’s take a look to see if this is the right option for you, and other possibilities such as a cash-out refinance or a home equity investment, also known as a shared equity agreement.
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What exactly is home equity?
When you first buy a home and take out a mortgage, you make a down payment (typically 20% of the purchase price). That is the portion of the house you actually own — the equity — and the bank owns the rest. Each time you make a subsequent mortgage payment, the amount that goes toward the principal builds the equity in your home so you own more of the property and the bank owns less.
In the beginning stages of your mortgage, your monthly pasyments will go more towards interest payments rather than the principal. However, gradually, that process reverses itself and you can build your home equity faster as the years go by. Plus, don’t forget that much of your monthly mortgage payment also includes disbursements for property taxes and insurance.
Over time, that equity really adds up. At some point, it could seem like a waste of valuable resources to let all that available cash just sit there. This might be a good time to figure out the optimal way to access your home’s equity and put the money to work for you.
One of the best ways to leverage your equity is to roll that money into an investment property or second home. If you have enough equity in your house, you could make a sizable down payment on a new property or even buy the house outright.
What are home equity loans?
Home equity loans are when you take out a loan for a percentage of that equity. You will be given a lump sum by the lender and you can turn around and use your home equity loan to buy another piece of real estate. Maybe you’ve been dreaming about a little cottage on the lake as a second home or an investment property to supplement your retirement funds, for example.
It’s important to remember, however, that a home equity loan is essentially a second mortgage on top of your existing mortgage, which means your primary residence is used to secure both loans. Plus, you’ll now have two more monthly payments, unless you have enough equity to essentially pay cash for the new property.
Also, keep in mind that getting a home equity loan is not a given. It’s much like getting your original loan and you must go through essentially the same process to be approved. This includes filling out an application and having your income and credit history scrutinized. To make this as painless as possible, make sure you find the right lender (since you don’t have to use the original mortgage lender for home equity loans).
Advantages and disadvantages of a home equity loan
One of the biggest benefits of home equity loans is potentially having access to a much larger amount of money than you could get through other sources. Plus, getting a fixed interest rate that’s usually lower than other types of borrowing, such as personal loans, will save money over the life of the loan.
The downside is that home equity loans put your first home at risk because it’s used as collateral to secure the loan. Additionally, you essentially have three mortgages to manage, between both your primary residence and your second home, plus the home equity loan. This could be a problem if you run into any financial difficulties such as a job loss or major illness. Finally, you’ll have to pay closing costs for the new house, which can take a chunk out of the money you have to invest in a new property.
Home equity line of credit (HELOC)
A HELOC is another way to use your home equity to purchase a second property. It differs from a home equity loan in that home equity loans disburse your money in a lump sum, whereas a HELOC is a revolving line of credit much like a credit card.
You can borrow as much (or as little) as you need during the draw period of the loan (usually about ten years), at which point the repayment period begins. Prior to that, you just need to make interest-only payments.
The biggest drawback to this type of equity access is that home equity lines typically come with variable interest rates. This makes them more difficult to budget for because you won’t always have fixed monthly payments. And, like with a home equity loan, your primary residence is used as collateral for the credit line.
Cash-out refinancing
A cash-out refinance is similar to a home equity loan in that it gives you access to your home equity. However, instead of taking on a second mortgage, you’re paying off the mortgage balance of your existing loan and swapping it out for a new mortgage.
You can then take the cash from that transaction and use it as a down payment on a second home or investment property. This means you will now have a separate mortgage from your first mortgage. So, unlike with a home equity loan or a HELOC, your main house is not used as collateral for the new mortgage. If something happens and you can’t make your mortgage payments, your primary home is not in jeopardy.
However, because a cash-out refinance results in a bigger mortgage, you’ll typically have a higher interest rate and monthly payment. And, because it’s a new loan, you will likely pay more in closing costs than you would with a traditional refinance.
How much equity can you borrow?
How much of your home equity you can borrow depends on several factors, such as how much equity you’ve built up in the home, the market value of your house, and how much you want to borrow. Essentially, the loan-to-value ratio (LTV) of your home plays a critical role in the loan amount you’re eligible for.
Other things that impact your borrowing power are your income and credit score. No matter the amount of equity you have in the home, if you have a poor credit history and not enough income — or a high debt-to-income ratio (DTI) — you may not be able to access your home equity through a home equity loan or other means.
But, assuming you are financially capable of getting approved for a home equity loan, cash-out refi, or similar, you should be able to take out a maximum amount of 85% of your accumulated equity.
For instance, if you bought your house for $500,000 and you have $300,000 in equity, you could conceivably get a $255,000 equity loan to buy another property. That might even be enough to pay cash for your new investment, so you wouldn’t be saddled with two mortgages.
Pro Tip
If you’re using it as a traditional rental property or an Airbnb rental property, you could generate a solid income to supplement your retirement funds or parlay into future investment properties. Don’t forget though, that you will probably have to pay closing costs or other fees that will eat into that loan amount.
Alternatives methods to buy a second property
Sometimes you don’t have the best credit score or you’re self-employed or between jobs, so your opportunities for accessing your home equity in more traditional ways are limited. In that case, here are a few other options to either get some equity from your home or otherwise come up with financing to invest in another property.
Home equity investment
A home equity investment (a.k.a shared equity agreement) is an exchange between you and an investment company where you receive a lump sum of cash in exchange for part of the existing (and possibly future) equity in your home. It’s kind of a form of shared ownership, except you own the title of the property and the investor is a silent partner who stands to profit from your house appreciating in value (or lose money if the house depreciates).
Because the investment company is counting on the fact that your house will gain in value, which is most common, there are lower credit score and income requirements than traditional loans. It’s not actually even technically considered a loan, as a matter of fact, and there are no monthly payments.
You can use that money however you choose, but you will have to pay it back either when the term is up or upon sale of the house, whichever comes first. How much you have to pay back is entirely dependent on whether the value of the house increased or decreased.
Retirement funds
Another possibility to finance a new investment property is to take a loan out against your retirement savings. Many employers have the power to approve loans against a 401(k) pension plan, but it can’t be more than 50% of the participant’s vested account balance (up to a maximum of $50,000).
You can use this money as a down payment on another property, but be aware that the repayment period of the loan is five years unless the loan is used to purchase a primary residence. If you fail to pay it back in that amount of time or you leave your job, you’ll need to pay income taxes on the money and probably early withdrawal penalties as well.
Reverse mortgage
This isn’t an option for everyone, but if you’re 62 or older, you could look into getting a reverse mortgage to purchase a rental property. This could bring in an income stream to help supplement your retirement funds.
A reverse mortgage is a type of loan that takes part of the equity in your home and converts it into payments to you. It’s sort of like advance payments on your home equity. The money you get is tax-free. Generally, you don’t have to pay back the money for as long as you live in your home. When you die, sell your home, or move out, you, your spouse, or your estate would repay the loan.
There are three kinds of reverse mortgages. A single-purpose reverse mortgage is offered by some state and local government agencies, as well as non-profits and proprietary reverse mortgages which come from private loans. There are also federally-insured reverse mortgages, also known as home equity conversion mortgages (HECMs).
Keep in mind that reverse mortgages usually come with origination fees, closing costs, and sometimes mortgage insurance premiums, which will cut into the money you receive. Also, interest rates are variable and the interest is not tax-deductible.
Be sure to comparison shop for reverse mortgage lenders before you apply.
Pro Tip
Before applying for any type of loan or refinancing options, be sure to do your research and comparison shop several different lenders to get the best terms and interest rates possible. Online lenders can often afford to be more competitive, like offering lower interest rates, than traditional banks because of lower overhead costs.
FAQs
Are interest payments on home equity loans tax deductible?
In some cases, such as if you use a home equity loan to remodel your primary home or put on an addition, the interest on the loan payments can be taken as a tax deduction.
However, if you use a home equity loan to buy an investment property or a vacation house, the interest on that loan amount would not be tax deductible. On the flip side, the interest you pay on the new mortgage can be deducted from your taxes.
What happens if the housing market drops and my home loses value?
Reduced market values do happen, which could mean that after refinancing your home in some fashion, you find yourself owing more on your house than it’s worth. But, lacking a crystal ball, there’s not a lot you can do about it.
On the upside, if you’re not planning on moving anytime soon, the housing market should turn around eventually and you’ll find that you can recoup your losses and then some.
Key Takeaways
- Leveraging your home equity can be a great way to purchase an investment property or a second home.
- There are several ways to access the equity you’ve built in your house, such as a home equity loan, cash-out refinance, or home equity line of credit.
- In some cases you could be looking at higher interest rates, closing costs, and other obstacles that can make loan approval difficult or out of your reach.
- There are other financing avenues available to help you realize the dream of owning a second home or investment property.
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