How to Use Home Equity to Buy a Second Home
Mortgage rates are still low and a lot of homeowners are thinking about expanding their portfolio. If you have a good chunk of home equity right now, it’s a good time to think about investing in a second property. I’ve been fielding questions from clients recently: Is now a good time to purchase an investment property? Can I use my home equity to buy a vacation home? What are the best ways to access my home equity for investing?
If you’ve been thinking about buying a second home as an investment property or vacation home, keep reading. Depending on your lifestyle and financial goals, tapping into your home equity to build your real estate portfolio might be a smart move.
How the Application Process Works
Applying for a home equity loan or line of credit is similar to refinancing your mortgage. Mortgage lenders will consider your debt-to-income ratio, credit history, income stability and employment status.
To qualify for most home equity loan products, homeowners need a loan-to-value ratio below 80%. This means that you can apply for up to 80% of your home’s value. To determine how much equity you have, find the difference between the market value of your home and your mortgage balance.
For example, if the appraised market value of your home is currently $760k and your mortgage balance is $425k, you’d have $335k in home equity. In this example, 80% of the home value would be $608k. You could potentially borrow up to $183k ($608k – $425k). Once you access your home equity, you can use that money as a down payment on a second property or buy an investment property outright.
Connect with an experienced mortgage broker. Many of my clients find out they have more options than they first thought. Give me a call to discuss your situation and we can talk about the first steps.
Best options for using your home equity to buy a second home or investment property:
There are four main ways to access the equity in your home. Each home loan option works a little differently.
1. Home Equity Loan
A home equity loan allows homeowners to borrow against the equity built in their home. A home equity loan is typically a fixed-rate loan with set terms and a fixed monthly payment. Common terms are 10-year fixed-rate home equity loans. You receive the funds in a one lump sum and pay off the loan in fixed payments over the life of the loan. Your home is used as collateral for the loan. You can use the funds however you want—a down payment for a second property, investing in commercial real estate, or simply taking a long-awaited vacation.
2. Home Equity Line of Credit
A home equity line of credit operates similar to a home equity loan, but instead of receiving a lump sum, you have access to a line of credit. Interest doesn’t accrue until you access the line of credit, and you have the option to pay it back as slowly or quickly as you want (within the limitations of the credit line). This can be a great option if you’re purchasing an investment property for a short period of time. For example, if you are flipping houses or doing quick renovations. In both scenarios, a home equity line of credit gives you access to the full amount when you need it and pay it off as soon as reasonable, which saves interest.
3. Cash-Out Refinance
A cash-out refinance streamlines the process by refinancing your first mortgage at current market rates. Depending on your loan-to-value ratio, you could refinance your mortgage for a higher amount and lower rate. For example, let’s say the current value of your home is $725k with a $450k mortgage balance and a 5% interest rate. You may be able to borrow up to 80% of your home’s value and refinance a new mortgage for $580k (80% of $725k) with a lower mortgage rate plus get $130k cash out ($580k-450k). That’s $130k available cash for a second home or investment property.
4. Reverse Mortgage
Homeowners who are 62 years or older can access equity through a HECM (Home Equity Conversion Mortgage), also known as a reverse mortgage. Homeowners with a reverse mortgage can access the equity in their primary residence while delaying (or skipping) mortgage payments. A reverse mortgage offers an alternative option to access equity and invest that equity elsewhere. Typically, borrowers can decide whether to access equity through a lump sum or a line of credit. Some homeowners take advantage of a reverse mortgage in order to stop making mortgage payments instead of accessing equity for other investments. Find out more here.
Pros and Cons of Using Home Equity to Purchase a Second Property
You might decide to use your home equity to invest in a second home, but it might be wise to consider alternative investments. For example, you could use your home equity to invest in stocks, start a new business, or purchase a commercial property. For homeowners looking to buy a second home or invest in residential real estate, here are the pros and cons to consider.
Advantages to using home equity to buy an investment property
- Keep your cash. By accessing the equity in your home, you don’t need to liquidate other assets or use your cash reserves. Keep your emergency funds and cash reserves in place.
- Boost your buying power. Tapping into your home equity will give you cash for a large down payment or even the full cost of an investment property. Bringing more cash to the table increases your buying power and gives you a competitive edge.
- Access lower interest rates. Cash-out refinancing and home equity products (home equity loans and home equity lines of credit) typically offer much lower rates than personal loans or other credit options. The bottom line is this: mortgage interest rates are still one of the cost-effective ways to borrow money right now.
- Generate cash flow. If you decide to purchase a second property as an investment, you’ll have the option to generate income through rent or other means. An investment property could increase in value, build equity and generate cash flow.
Drawbacks to using home equity to buy a second home or investment property
- Multiple loan payments. Buying a second property means a second mortgage in addition to your primary residence unless your first mortgage is paid off. If you use a home equity loan or home equity line of credit, you might have a third loan payment in the mix.
- Your primary residence could be at risk. When you borrow against the equity in your home, your primary residence as collateral for the new loan. If you have trouble making payments on the loan, it might put your primary residence at risk of foreclosure.
- Closing costs and additional fees. Whenever you apply for a new loan (whether it’s a second mortgage, a home equity loan, or refinancing your mortgage), you’ll incur closing costs. A quick reminder that there will be closing costs for each new loan (home equity loan, mortgage refinance, the mortgage on a second property). Depending on the terms of each loan, closing costs may be higher than expected.
Using home equity to purchase a second property while mortgage rates are low is a smart move. If you’re a homeowner with more than 20% equity in your home, you have a lot of investment choices right now. Home values continue to stay strong across the west coast, and many properties offer investment opportunities to homeowners who are ready to take action.
Choosing the best loan option can be a difficult decision. If you’re ready to buy a second home or investment property, we can help you through the process. We partner with mortgage lenders throughout California, Oregon, Washington, and Colorado. Mortgage rates are still low and now is the time to take action.