Using your home equity to buy a home – Forbes Advisor
Editorial Note: We earn a commission on partner links on Forbes Advisor. Commissions do not affect the opinions or ratings of our editors.
If you’ve owned a home for a few years, you’ve probably seen a significant increase in your home’s equity. There are several ways to leverage the equity in your home to fund other purchases or even an upgrade to a new home. A key way to use the equity in your current home to buy another home is through a home equity loan. With this type of loan, you will receive the funds in a lump sum to use as you wish, such as buying a second home or an investment property.
However, using a home loan to buy another home also comes with risks. Just like a regular mortgage, a home equity loan uses your home as collateral, which means the bank could seize it if you seriously miss your payments.
In addition, each lender has their own eligibility criteria when it comes to obtaining approval for a home equity loan and a mortgage on the secondary residence, if necessary. For example, some lenders might not be willing to approve you if you use a home equity loan to cover your down payment.
Here are the things to consider if you want to use a home equity loan to buy a new home.
What is a home equity loan?
A home equity loan is a type of fixed rate loan secured by your home. You can usually borrow up to 80% of your home’s equity through a home equity loan, depending on the lender.
Unlike a home equity line of credit (HELOC) which allows you to tap and repay your line of credit multiple times, you will receive the funds for your home equity loan as a lump sum. You’ll then repay that amount in equal installments over your repayment term, usually five to 30 years, depending on the lender.
Since a home equity loan is secured by your home, it is considered less risky for the lender. It therefore tends to offer a lower interest rate than other types of loans. Your rate will also depend on other factors, such as your credit, income, and debt-to-income ratio (DTI).
Using a home equity loan to buy a second property
Although you can use a home equity loan to buy a second property, it’s important to consider whether you’ll be using the funds for another home or an investment property. Here are some pros and cons to keep in mind if you’re buying a second property:
Benefits of using a home equity loan to buy a second home
- Lower interest rates. Because a home equity loan is secured by your home, it will likely come with a lower rate than you would get with other types of financing.
- Can provide cash for down payment or all-cash offer. If you’ve accumulated a large amount of equity in your home, but don’t have a lot of cash on hand for a down payment or an all-cash offer, taking out a home equity loan could be a useful option.
- No surprise price increases. Home equity loans come with fixed interest rates, which means your rate and payment will stay the same for the life of the loan.
Disadvantages of using a home equity loan to buy a second home
- Foreclosure risk. Using your home as collateral for a home equity loan means the lender could seize it if you don’t meet your monthly payments and end up in foreclosure. Missing payments on a home equity loan will also hurt your credit score, even if you’re current on your primary mortgage.
- Increase your debt. If you still owe money on your first mortgage, taking out a home equity loan could cause you to go into over-indebtedness, especially if you take out another mortgage on the second home. This could make it difficult to pay payments if you need to cover unexpected expenses, such as sudden medical bills or job loss.
- You will likely pay closing costs. Home equity loans come with closing costs just like regular mortgages, usually 2-5% of your loan amount. Remember that you may also have to cover additional closing costs if you take out a mortgage on the second home.
Using a home equity loan to buy an investment property
Buying an investment property through a home equity loan is different and sometimes more complicated than using the same type of loan for a second home. This is mainly because investment properties are considered riskier by the lender, so you will generally face higher requirements (and costs) when seeking financing for such property.
Consider these pros and cons before using a home equity loan to purchase an investment property:
Benefits of using a home equity loan to buy an investment property
- May lower your interest rate. The lower rates offered on home equity loans can help you save money on interest charges, especially if the mortgage rate on the investment property is higher.
- Help cover your down payment. Since lenders view home loans as riskier than traditional mortgages, they sometimes require a higher down payment. A home equity loan can help you find enough money to cover this. Plus, putting more money aside could lower your monthly payments since you’ll be borrowing less on the mortgage itself.
- Could help you qualify for financing more easily. A home equity loan is generally easier to obtain than a mortgage for a second property, especially since investment property mortgages generally require a larger down payment than a traditional loan.
Disadvantages of Using a Home Equity Loan to Buy Investment Property
- You add more debt. To take out a home equity loan, you must pledge the equity in the home you own. This means that you will turn an asset into debt, while adding more debt through the home equity loan and a mortgage on the investment property, if necessary.
- More risk if home values change. The housing market fluctuates constantly, so if you own two properties and the value of the home drops, you could end up owing more on your mortgages and on the equity in your property. A decline in home market values could also make it difficult to resell the investment property.
- More risk if you default. If you fail to repay your home equity loan, you could lose both the principal residence you used as collateral and your investment property if you seriously default on all loans.
- I probably can’t deduct the interest. Unless you use your loan funds to build, buy, or significantly improve your principal residence that secures the home equity loan, you will not be able to deduct the interest you pay on the loan from your income taxes.
Alternative Financing Options for Buying Another Home
If using a home equity loan to buy another home doesn’t seem right for you, here are some other options to consider:
If you already have a large amount accumulated in a savings account, it may be a good idea to use it as a down payment to avoid further debt.
However, this will deplete your cash reserves and could leave you financially vulnerable in the event of unexpected expenses.
Refinancing by collection
With a cash-out refinance, you will take out a mortgage for more than you owe on your home. You will then use these funds to pay off your existing mortgage, leaving you with the extra amount, less closing costs, to use as you wish.
Keep in mind that you’ll generally need a credit score of at least 620 to be approved for a cashout refinance, but if you want the best rates available, you’ll likely need a score of 700. or more. Remember that because you are paying off your old mortgage with a larger loan, your monthly payments will increase.
A personal loan can generally be used to cover almost any personal expense, including the purchase of a home in some cases. Unlike home equity loans, most personal loans are unsecured, which means you don’t have to worry about collateral.
But because there’s more risk to the lender, you’ll likely end up with a higher interest rate on a personal loan than on a home equity loan. Also, while you can borrow up to $100,000 or more with a personal loan, depending on the lender, it might not be enough to fully cover the cost of a new home or even a down payment.
hard money loan
If you are buying an investment property, you might consider taking out a hard money loan. This type of loan is a short-term asset-based financing, that is, it is secured by real estate. To qualify, the property you buy must generally be in distress and in some stage of disrepair.
With a hard money loan, the property you plan to buy will be used as collateral for the loan, and your loan amount will depend on how much the lender expects the property to be worth after it is renovated. Hard money loans also tend to have a much faster turnaround time, which could make them a good option if you need the money fast.
However, keep in mind that these loans are riskier and usually not offered by commercial banks. Instead, you will need to work with a private company or an individual. This added risk for the lender also means that interest rates are generally higher than what you would get with a traditional loan.