Owning a second home can be a worthwhile investment if you’re able to use it to generate income or enjoy it as a vacation home. One way to purchase a second property is with a home equity loan -- as long as you’re aware of the risks inherent in borrowing against any equity you’ve built up in your primary residence.
Homeowners regularly tap into their home equity to pay for renovations or consolidate debt. But a home equity loan, or a home equity line of credit, can also be used to purchase a second home. Before moving forward, it’s worth considering the trade-offs. Here’s what you need to know about tapping home equity to fund a down payment for another house.
How to use home equity as a down payment for a second home
In order to leverage a home equity loan or a HELOC as a down payment on a second home, you will need to follow the steps below.
1. Determine how much you need to borrow
Make sure you qualify for a large enough home equity loan to cover your down payment. Most lenders require at least a 15% to 20% down payment in order to buy a second property, which is much higher than for a primary residence. Your home equity is the difference between what you still owe on your mortgage and the current appraised value of your home, expressed as a percentage of your home that you’ve already paid off. If, for example, you owe $300,000 on your mortgage and your house is worth $500,000, then you have $200,000, or 40% equity in your home.
Then, to determine how much of your equity you can borrow against, you have to calculate your loan-to-value, or LTV, ratio, which is your outstanding mortgage balance divided by your home’s current appraised value. The calculation for that $500,000 property would be:
$300,000 / $500,000 = 0.60
This means you have a 60% LTV ratio. Lenders will typically let you borrow between 75% and 90% of your available home equity. To determine that amount, do the following calculation, which assumes a lender will let you borrow up to 85% of your home equity:
($500,000 [current appraised value] x 0.85 [maximum equity percentage you can borrow]) – $300,000 [outstanding mortgage balance] = $125,000 [amount the lender will let you borrow]
2. Prepare the application
You’ll need to have all of your financial paperwork ready to go for your lender to review. That means showing proof of adequate income and stable employment through documents such as tax returns, pay stubs and Form W-2s, as well as the paperwork for your existing mortgage showing that you’ve been making consistent on-time monthly payments. Whether you’re approved will depend on such factors as how much equity you have in your home, your credit score (700 and higher will get you the best rates) and your debt-to-income, or DTI, ratio. Lenders typically like to see a DTI of 36% or less, but no higher than 43%.
3. Compare lenders and rates
The more banks and lenders you interview, the better your chances are of finding the lowest rates and fees available. Homeowners can save an average of $1,500 over the lifetime of their loan just by getting one extra quote and an average of $3,000 by getting five quotes, according to Freddie Mac.
Be sure to read the fine print. Some lenders may offer a lower interest rate but charge high fees that cancel out any savings on interest. Other banks offer preferred rates to existing customers, or new customers, willing to open a checking account, for example. Also, keep in mind that not all lenders allow for a home equity loan to be used for the down payment on a second home.
4. Select the best offer
Once you’ve interviewed multiple lenders, choose the loan whose rates and terms are most favorable for your situation. If you can comfortably pay off your loan in 10 years, for example, you can choose a lender that offers a lower interest rate but a shorter repayment period. If you need breathing room in your budget over the next few years, you may want to choose a HELOC so you can make interest-only payments until your budget can afford higher monthly payments.
5. Obtain funds and make purchase
It can take anywhere from two weeks to two months to receive your funds. If you choose a home equity loan, the entire amount of your loan will be disbursed to you upfront. If you take out a HELOC, you can start making withdrawals as needed. Depending on your lender, you can typically access your HELOC funds through checks or a debit card provided by the lender.
Pros and cons of using a home equity loan as a down payment for a second home
If you can afford it, an investment property can produce valuable supplemental income, but it’s a risk to use your primary residence as collateral to secure a home equity loan for a down payment on a second home.
Long repayment periods: Home equity loans can have repayment periods of up to 30 years, which helps you keep your monthly payments low over time. HELOCs usually allow you to make interest-only payments for the first 10 years, during what’s called the draw period, which means you can make much lower monthly payments for an extended period of time.
Pay additional fees: You’ll likely have to pay lender’s fees and closing costs for your home equity loan. That means you’re paying those costs twice, because you must also pay those fees when you close on the mortgage for the investment property you’re buying.
What home equity loan options do I have?
There are two main types of home equity loans for individuals to choose from. The first is a standard home equity loan, which has fixed interest rates for the entirety of the loan and provides you with a lump sum of cash upfront.
A home equity line of credit, or HELOC, functions more like a credit card that you can make continuous withdrawals from and have variable interest rates that rise and fall according to economic conditions. You also only pay interest on the amount of cash you take out.
Is it a good idea to use home equity as a down payment for a second home?
You should only finance the purchase of a second home with a home equity loan if you can afford multiple mortgage payments over the long term. An investment property can generate income and pay for itself when managed responsibly, but when it comes to being a landlord there will always be economic factors involved that are out of your control. If, for example, a renter moves out, can you afford to cover the mortgage payment on your own for a few months while you find a new tenant? If you lose your job during a time of economic uncertainty, do you have enough savings to stay current on your monthly payments until you find a new role? These are factors to consider carefully when your primary residence is on the line.
“Whether your home is paid off or not, tapping home equity isn’t free money and it’s not the same as going to the ATM and withdrawing money from your account,” says Greg McBride, chief financial analyst for Bankrate. “This is borrowing, which must be repaid with interest, and it puts your single largest asset on the line in the event of default. That doesn’t make it a bad option, just one to go into with both eyes open.”
In addition to the expense of a down payment and new monthly mortgage payment, don’t forget about all of the other costs associated with buying a new home. You’ll need to furnish the home, as well as take care of its maintenance and pay property taxes.
Other ways to cover a down payment for a second home
Generally speaking, you should avoid using your first home as collateral to fund a down payment for a second property. There are alternative financing options worth considering that don’t require risking eviction.
- Personal loan: Interest rates for personal loans tend to be higher than interest rates for home equity loans, because these types of loans aren’t secured by your property, which means lenders have less recourse to recoup their funds if you stop making payments on your loan. Right now, the average rate for a personal loan is around 11.5%, according to Bankrate.
- Cash-out refinance: A cash-out refinance is when you take out a new mortgage to replace your existing mortgage to receive more favorable rates and terms. You receive a lump sum of cash that then gets added back onto the balance on your new mortgage.
- 401(k) loan: Some 401(k) plans allow you to borrow up to 50% of your retirement account balance, but you must repay the loan within five years. If you can’t replenish the funds in time, you’ll face IRS penalties, canceling out the benefit of the 401(k) loan.
- Wait and save: If you aren’t in a rush to buy a property, consider waiting and saving the old-fashioned way. You can put your savings into a high-yield savings account or an interest-yielding account while you build up the funds to cover a down payment, avoiding exposing your home to foreclosure.