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Real estate is a relatively safe investment since it seldom declines in value and you get to use or rent the property while it appreciates in value. If you are looking to buy a second home, you may be wondering if you can use a home equity loan from your primary residence to do so.
If you meet the eligibility requirements, you can almost always use the home equity you’ve built in one property to purchase another house.
This is one of the cheapest borrowing options for qualified borrowers, making this a great strategy for most homeowners.
Home Equity Options to Purchase a Second Home
Using Home Equity to Purchase Another House
There aren’t any regulations for how home equity loan or home equity line of credit (HELOC) funds can be used, so you can typically use your home equity to purchase a second home—perhaps an investment or rental property.
While there are many benefits of doing so, the details of your individual situation will decide if this strategy makes sense for you.
Here are a few things you should consider as you make your decision.
Mortgages on Second Homes Are Harder to Secure
First, securing a second home mortgage is more difficult than a first mortgage. Mortgage lenders scrutinize your ability to make payments on two mortgages and know that in a crunch, you’ll default on the new 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 or HELOC 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 or HELOC as a down payment or to fund the entire purchase price of the new home.
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 or HELOC and end up in default.
Since your primary residence serves as the collateral on the home equity loan or line of credit, you would lose your home in a foreclosure.
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 another 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?
It’s worth evaluating whether it would be best to take out a new mortgage or bridge loan to pay for 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.
Cash-Out Refinance Instead?
Another viable alternative is a cash-out refinance. With this, you refinance your first mortgage for an amount higher than you currently owe and are given a lump sum of money for the difference.
For example, if you owe $200,000 on your mortgage and refinance it to $250,000, you would receive $50,000 in cash.
While this will increase your existing mortgage balance, you won’t have a second lien against your home like you would with a home equity loan or HELOC.
>> Read More: Cash-Out Refinance vs. Home Equity Loan
Home Equity Loan & HELOC Eligibility Requirements
Home equity loans and HELOCs are ways for homeowners to access and use the equity they have built up in a home. Here are the common eligibility requirements and what the application process usually entails.
The maximum loan amount or line of credit 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%.
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%. So, you may be able to borrow up to 25% of the home’s value, which would equal $50,000.
You can calculate your home equity and determine how much you may be eligible to borrow with our home equity loan calculator.
You can apply for a home equity loan or HELOC online or at a local bank branch office.
The process is similar to applying 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. You can learn more about common closing costs and fees here.
Home Equity Options to Purchase a Second Home
Author: Kimberly Goodwin, PhD