For most American homeowners, their home is the single largest asset in their investment portfolio. You can borrow money to purchase real estate at a low interest rate and deduct the mortgage interest on your federal taxes.
Real estate is a relatively safe investment since it seldom declines in value, and you get to use the property while it appreciates in value. For all of these reasons, homeowners might consider buying a second home to use as an investment or for vacation. Furthermore, they might consider using a home equity loan to fund the purchase.
What Is a Home Equity Loan?
A home equity loan is a way for homeowners to access and use the equitythey have built up in a home. The maximum loan amount a borrower can get is dependent upon the current outstanding mortgage balance and the current value of the home.
Lenders generally require that the combined loan-to-value ratio of the mortgage debt and home equity debt doesn’t exceed 85 percent. Consider an example where your home is worth $200,000 and you currently owe $120,000 on your mortgage. Your current loan-to-value ratio is 60 percent. So, you may be able to borrow up to 25 percent of the home’s value, which would equal $50,000.
You can apply online or at a local bank branch office. The process is similar to a borrower’s experience when they apply for a mortgage. In addition to the application, borrowers need to be prepared to provide copies of all billing statements on debt accounts, W-2 forms, and pay stubs. Most lenders don’t charge borrowers any closing fees on home equity loans.
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Can I Use My Home Equity Loan for My Second Home Purchase?
There aren’t any regulations telling borrowers how they can use the funds from their home equity loan. So you can use your home equity loan to purchase another home – perhaps an investment or rental property. Whether it is a good idea or not depends on the details of your individual situation. There are a few things you should consider as you make your decision.
Mortgages on Second Homes Are Harder to Secure
First, financing a second home is more difficult than financing a primary residence. Mortgage lenders scrutinize your ability to make payments on two mortgages and know that in a crunch, you’ll default on the second home.
In addition, many low-cost investment properties do not adhere to codes and specifications that mortgage lenders may require. Using the funds from a home equity loan allows a borrower to avoid those difficulties.
Down Payment or Entire Purchase?
Second, you need to consider whether you’ll use the funds from the home equity loan as a down payment or to fund the entire purchase price of the property. The interest rate on the home equity loan may be slightly higher than one you could get on a second mortgage, and the payments may be larger because you’ll have to finance the purchase over 10 to 15 years instead of 15 to 30 years.
In addition, you face the potential for a large loss if you can no longer make the payments on the home equity loan and end up in default. Since your primary residence serves as the collateral on the home equity loan, you would lose your home in a foreclosure.
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Total Debt Level
Third, remember to consider your total debt levels if you use the proceeds from the home equity loan as a down payment on your second home. A lender evaluating you for a mortgage on a second home will look at your debt-to-income ratio after considering all of your monthly debt payments.
In addition to other non-housing debts you may have, like credit card or student loan debt, this will include the payments on your new mortgage for the second home, the mortgage on your primary residence, and the home equity loan. Make sure these debt obligations do not exceed 40 percent to 43 percent of your monthly income. Exceeding this threshold may make it harder to qualify for new loans or credit in the future.
Second Mortgage Instead?
Finally, evaluate whether it would be best to take out a new mortgage on the second home. The application process is more difficult than it is for a home equity loan, but you would not be at risk of losing your primary residence if you could no longer make the loan payments.
Since the second home would serve as the collateral on the new mortgage, your primary residence would no longer be at risk. Although borrowers usually don’t pay closing and origination costs on home equity loans, you do need to pay all of those costs at closing on a new mortgage for a second home.
In the end, you’ll need to figure out how much you can borrow with a home equity loan and consider how the borrowing costs and risk stack up against other financing options.