The Complete Guide To Using A HELOC For A Down Payment On A Second Home
David Collins6-minute read
September 01, 2023
You may not know that you can use the equity you’ve built in your primary home to make a down payment on a second home, such as a lake cottage or an investment property. This can be done through a cash-out refinance, home equity loan or a home equity line of credit (HELOC). While Rocket Mortgage® doesn’t offer HELOCs at this time, it’s important to understand these loans when deciding whether they’re the best option compared to other ways to access your equity.
What To Consider When Using A HELOC For A Down Payment
A HELOC is a type of second mortgage that allows homeowners to borrow money against the equity they have in their home and use it as a revolving line of credit. Though it’s not a credit card, a HELOC works very much like one, and usually at a far lower interest rate. You can borrow up to the established credit limit and make payments on the principal plus accrued interest on what you’ve borrowed.
You can use HELOC funds for almost any purpose, including as a down payment on a second home. Your bank will set the credit limit on your HELOC based on the amount of equity you have your current home and the balance of your mortgage. The credit limit will typically be set at no more than 85% of these combined amounts.
It’s important to keep in mind that using a HELOC as a down payment on a second home will result in three monthly payments: your first mortgage payment, your used HELOC balance and your second home’s mortgage payment. And since your home is used to secure the loan, you risk losing your home (or homes) if you fail to make payments.
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Home Equity Loan Vs. HELOC: What Are They?
It’s easy to think that a HELOC is the same thing as a home equity loan, but it isn’t.
The main difference between a home equity loan and a HELOC is that in a home equity loan, you get an upfront lump sum that you repay in fixed payments, whereas a HELOC lets you tap into equity as needed up to a certain limit. HELOCs typically have a variable interest rate (one that changes) versus fixed rates, which are typical in a home equity loan.
Finally, we should note that while Rocket Mortgage doesn't offer HELOCs at this time, we do offer a Home Equity Loan.
How To Use A HELOC For A Down Payment On A Second Home
Since a HELOC is like a credit card, you can borrow against it, pay off the balance, and borrow again up to the credit limit for as long as the draw period lasts. If your loan is large enough, you can technically use some of the funds for a down payment and have extra to make repairs and improvements to the property. Here are the steps to using a HELOC for this purpose.
1. Determine Your Loan-To-Value (LTV) Ratio
Your loan-to-value ratio measures the appraised value of a home that you want to buy against the loan amount that you’re seeking to borrow. For instance, if you want to buy a house valued at $100,000 and you can make a $10,000 down payment, your loan is $90,000 or 90% LTV.
Put simply: The lower your LTV, the less risky your mortgage will be perceived to be by prospective lenders.
Here’s an example of the maximum amount of credit you can qualify for based on how the LTV is calculated for a HELOC.
First, know that most lenders want to keep the LTV ratio on a HELOC to 85% or less.
If your home’s appraised value is $500,000 and the amount you still owe on your mortgage is $300,000, you have $200,000 in equity in your home.
Multiply the home’s current value by 85% (0.85). $500,000 x 0.85 = $425,000
Now, from that amount, subtract how much you currently owe on your first mortgage.
$425,000 - $300,000 = $125,000
$125,000 would be your maximum allowed HELOC.
2. Set Your Budget
If you think you’re financially secure enough to afford a second home loan, it’s important to make a budget. If you’re taking out a HELOC to make your down payment, you’re taking on two new monthly payments, one for the line of credit and one for the second mortgage. Plus, you’ll have to pay the closing costs for both loans, which are typically 2% – 6% of the loan amount.
Also remember there will be property taxes, homeowners insurance and maintenance costs on the second home.
3. Apply For A HELOC For The Down Payment
Much like when you apply for a mortgage, a lender will want to make an assessment of all your financial commitments. They’ll determine the maximum amount of credit they can offer by calculating the loan-to-value ratio of your current home, as discussed above. Once you’ve closed on your HELOC, you can apply any or all of those funds to a down payment on a second home.
To qualify for a loan on a second home, you’ll need a down payment of at least 10% on a conventional loan.
4. Find A Second Home
Finding a second home is a very similar process to finding your first home. Find a good real estate agent who knows the area extremely well—they’ll be able to point you to the best neighborhoods for your lifestyle and budget. A good realtor can also be a helpful asset to have in your corner throughout the home buying process.
5. Apply For A Loan For Your Second Home
Much like buying a primary home, buying a second home requires a down payment and a mortgage, (unless you’re paying cash). Typically the down payment on a second home is higher, at least 10%, because banks see second mortgages as a riskier investment.
6. Close On Your Second Home
Closing on your second home is the same as closing any other mortgage and can take 30 to 45 days in most cases. Remember that you’ll now have two mortgage payments, plus your monthly minimum HELOC payment.
Advantages And Disadvantages Of Using A HELOC For A Down Payment On A Second Home
Using a HELOC for a down payment on a second home provides instant funds for what can be a large upfront payment — and preserves your savings for other uses. During what is known as the “draw period,” which can last 5 – 15 years, you can get funds up to the credit limit and only make payments equal to the interest on the loan.
During this time, no more funds can be withdrawn and the borrower has to make payments on both the interest and the principal. You also risk losing your primary home to foreclosure if you stop paying on the HELOC.
Other Down Payment Options On A Second Home
Home Equity Loan
Though similar to a HELOC, a home equity loan is different in that you receive a lump sum payment and make monthly payments set at a fixed interest rate (a HELOC will carry a variable rate and you pay debt down when you can).
One of the best reasons to use a home equity loan to buy a second home is that, because it uses the fixed collateral of your home equity, it’s considered a safer risk for banks and therefore has a lower interest rate than, say, a credit card or personal loan.
However, taking a home equity loan is not without risk. It turns an asset (your home’s equity) into debt, adds another mortgage payment to your budget and makes you financially vulnerable to downturns in the real estate market.
Another way to get funds for a down payment on a second house is by doing a cash-out refinance on your primary home’s mortgage. In a cash-out refinance of your mortgage, you take advantage of the equity you’ve built by taking on a larger mortgage, paying off your current mortgage, and pocketing the difference. This difference is what you can use as a down payment.
If you have enough savings to pay the down payment in cash, you avoid the trouble and time it takes to get a loan. You also save all the money you would pay in interest over the life of a loan. And it can advantageous to your credit score if you don’t take on any more debt.
The downside to making your down payment in cash is that the funds are now sunk into the real estate investment. You don’t have access to them for other expenses, known and unknown. If you can pay cash without significantly draining your cash reserves, this might be a good option.
The Bottom Line
Taking a HELOC on your primary home can be a great way to get funds to apply to the down payment on a second home. Based on how much equity you have in your house and its current value, you can borrow up to the established credit limit and make payments on the principal plus accrued interest on what you’ve borrowed.
Once you have sufficient funds to make the down payment on a property, you can apply for a second home loan.
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