People tap into their home equity for a variety of reasons. One potential use of home equity funds is to purchase another house or investment property.
There are both pros and cons to borrowing from your home equity, and there are a few ways to do it. Here’s a breakdown to help you decide if using your home equity to buy another house is a good idea for you.
- Home equity can be a great source of funds when you need a large, lump sum of cash—including when you’re buying another home.
- There are three main ways to borrow from your home equity: a home equity loan, a home equity line of credit, or a cash-out refinance.
- Using home equity to buy a property has clear benefits, but there is risk involved when using your home as collateral.
- Each type of equity borrowing has pros and cons, so it’s important to work with a professional who can go over the best options for your personal situation.
Advantages of Using Home Equity To Buy a Property
Home equity borrowing can help you buy a second property without having to rely on other sources of savings or other non-collateral loan options that may have higher interest. Here are some advantages to consider:
- Lower interest rates: Mortgage rates on investment properties are higher than they are for a primary residence, said Tiffany Brown, broker-owner and loan originator with Motto Mortgage Summit in Castle Rock, Colorado. “So if you have a significant amount of equity, the rates are going to be lower if you are borrowing against your primary home,” she says.
- Easy to qualify: Some products that allow you to borrow from home equity, such as a home equity loan or home equity line of credit, can be easier to qualify for than other types of loans since your home serves as the collateral.
- Preserve your other assets: It’s rarely a good idea to borrow from retirement funds, and it’s scary to leave yourself with no emergency fund. Ample home equity can provide another source of cash when pursuing an investment property.
- Create an income stream: If you rent the second home or decide to fix it and flip it, you can potentially get a return on your investment.
Disadvantages of Using Home Equity To Buy a House
Any time you use your home as collateral, you should think it through carefully. Here are some potential pitfalls to be aware of:
- Increased debt burden: “It's going to make your payments higher because whichever route you go to access and tap into that equity, it's an additional loan,” said Brown.
- Things may not work out: If you are planning on renting out the second property or flipping it for resale, should that plan fall through, it could impact your finances.
- Extending your loan burden: If you do a cash-out refinance, you’ll likely be starting over with a 30-year mortgage, while home equity loans and lines of credit can last for a number of years as well.
- Risking your home: Whenever you borrow from home equity, you’re taking a gamble. If property values suddenly drop, for instance, you could end up with very little equity. Plus, if you have trouble making payments, you risk foreclosure.
How To Use Home Equity To Buy a Home
Homeowners have a few different options for tapping into their home equity to buy another home. Choosing the right one really depends on your financial situation and goals.
Home Equity Loans
A home equity loan is a second loan on your home that uses your equity as collateral. These are typically fixed-rate, fixed-term loans. You can usually borrow up to 85% of your home value, across both your first loan and any subsequent ones. So if your home is worth $400,000 and your first mortgage balance is $200,000, that means you could take a home equity loan up to $140,000 ($200,000 + $140,000 = $340,000, which is 85% of the home value).
On the plus side, because you’ll have fixed monthly payments over the life of the loan, there are no big rate increases to worry about. Also, closing costs are minimal or covered by the lenders in some cases. The downside is that interest rates will be higher than the rates on a traditional home loan or refinance since you’re adding on more debt with your primary home as collateral.
Home Equity Lines of Credit (HELOC)
A HELOC is also a second lien on your home, but it’s a revolving source of funds, similar to a credit card, said Brown. You can take what you need from the credit line, and keep drawing from it for a set amount of time (usually 10 years).
“It's typically a little bit easier to qualify for a HELOC than a cash-out refinance, because usually you're looking at a lower loan amount,” said Brown.
On the positive side, closing costs for HELOCs are usually much lower than traditional home loan products, and you only have to make minimum, interest-only payments during the draw period. That gives you access to cash as you need it, and then by the time the full repayment period begins, you will (hopefully) either have a rental income stream to cover it, or you might have resold the home for a profit.
As for the cons, the interest rate on a HELOC may be higher than a traditional home loan, said Brown, and rates are usually variable. Between that and the fact that you make interest-only payments during the draw period, once the repayment period begins, it could make for a sizable addition to your monthly expenses.
A cash-out refi basically replaces your existing mortgage and adds on an additional amount above what you currently owe. “The difference between the loan payoff amount and any closing costs is the cash that you can net from the cash-out refi,” said Brown.
In a low-interest-rate environment, a cash-out refinance that lowers a borrower's rate significantly could actually result in a similar monthly payment to what the person was paying on their original loan, said Brown. “But if someone comes in and their primary mortgage is already at a really low rate, the HELOC might be a better option for them,” she adds. “There's a lot of factors to look at when we're determining which way to go.”
Among those factors: A cash-out refinance is a more involved application process than a HELOC or home equity loan in that it follows the same guidelines as any other mortgage. It will also have higher closing costs, and you’ll restart your 30-year mortgage clock.
Reverse mortgages have a lot of complex rules and requirements, but it is actually possible to use this product to buy a new home. Homeowners who are age 62 or older could apply for a Home Equity Conversion Mortgage (HECM) for Purchase, but here’s the catch: The home that is purchased must be used as the primary residence. You won’t be using an HECM to buy an investment or vacation home.
Frequently Asked Questions (FAQs)
How do you determine how much equity you have in your home?
You can estimate your home equity with a simple calculation: Divide what you currently owe on your mortgage by your home’s value. So for example, if you owe $300,000 and your home value estimate is $500,000, you’d get .06, or 60%. That’s how much you still owe on the house, also called our loan-to-value ratio (LTV). Next, subtract the LTV percentage from 100%, and that’s how much home equity you have. In this case, 40%.
How do you increase the equity in your home?
You can increase the equity in your home in one of two ways: Either owe less, or increase your home’s value. Making extra mortgage payments that go toward the principal can lower your total loan amount. As far as home value, there are some home improvements that can raise the value of your home, while natural growth in the real estate market could also help elevate home value.
How long does it take to build equity in your home?
It depends. The smaller the down payment was when you first bought the home, the longer it will take for you to build equity. With each mortgage payment you make, you will be reducing the principal amount owed on the home. Over time, you will increase your equity as your loan principal amount decreases. In addition, when home values rise or if you make significant home upgrades, that can also accelerate the increase in your home equity.