Can I Use A Home Equity Loan To Buy Another House?: A Guide
Katie Ziraldo6-minute read
January 11, 2023
Can you use a home equity loan to buy another house? The short answer is yes, although the advantages and disadvantages of this course of action may depend on what the second property is used for. It could also be a good option for those interested in buying an investment property.
In this article, we will explore home equity loans, how they can be used to obtain property, and both the benefits and drawbacks of using your equity to buy a second house.
What Is A Home Equity Loan?
To understand how to use home equity toward your next property purchase, you must first understand how a home equity loan works. A home equity loan is a type of second mortgage that allows you to access the equity you’ve built in your home.
Home equity is the difference between what your home is worth and what you owe your lender – also known as the amount of your home that you actually own. As you make mortgage payments and reduce the balance of your loan, you build equity. With a home equity loan, you can receive that money with a lump sum payment that is then paid back to the lender in fixed installments overtime.
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Using A Home Equity Loan To Buy A Second Home Vs. An Investment Property: What’s The Difference?
If you’re considering using home equity to buy a second house, there’s one important question to ask yourself: Are you buying this property as a second home or as an investment?
These lines can be blurred, but it’s important to have clear goals in mind as they will directly impact your ability to receive financing. Some of the key differences between using a home equity loan for a second home and investment properties include:
- The ability for an investment property to pay itself off. Please note that calculating the internal rate of return (IRR) is key to making sure this happens.
- The greater likelihood of being able to afford an investment property via a home equity loan in comparison to a second home, which typically requires larger down payments and better credit.
Advantages Of Using Home Equity To Buy An Investment Property
A home equity loan can make buying a second property less expensive and give more liquidity to the buyer. When using home equity specifically to buy an investment property, there are a few distinct advantages.
You Could Increase Your Down Payment
Home equity loans are received in a lump sum payment, giving you more cash to use toward your next property. By choosing to put more of that money toward your down payment, you can potentially lower your monthly payments and interest rates.
You Could Solve Financing Challenges
Second properties are typically more difficult to finance due to stricter down payment requirements, making a home equity loan a more convenient and affordable solution for most borrowers looking to buy investment properties.
Interest Rates Will Likely Be Lower
Lenders spend less time originating home equity loans, which may save you money, as it typically means lower fees and closing costs. But perhaps the biggest advantage of this option is the potential to lower your interest rates.
Home equity loans offer lower interest rates because they are secured by collateral in the form of real estate. This means by utilizing a home equity loan, you can avoid the hefty interest rates you would encounter through other forms of financing, like hard money and personal loans.
Disadvantages Of Using Home Equity To Buy An Investment Property
Despite the benefits of using home equity to buy an investment property, there are also some potential risks.
You Are Trading Assets In For Debt
Getting a home equity loan means turning assets into debt because you are effectively taking the part of your home that you own and tying it up in another loan. Although this may be worth it in some scenarios as it prevents you from having to withdraw money from existing investments, there are also implications to having higher debt that you must consider.
You Are Leaving Yourself Vulnerable To Shifts In The Housing Market
All homeowners are technically vulnerable to these shifts, but by owning two properties, you are essentially doubling your potential risk to changes in the housing market. If either home’s value lessens, you may end up owing more on your mortgage and home equity loans, which can spread some homeowners too thin.
And if you default on the loan, you could potentially lose both your primary and secondary properties, as both are held as collateral. You should also note that reduced market values could affect your ability to resell the investment property.
You Could Have Three Mortgages For Only Two Homes
A home equity loan is often taken out in the form of a second mortgage. Combine this with the financing you will need for your second home, and it’s likely you will end up with three mortgages for only two properties.
Although this is important to remember, it’s not necessarily a deal breaker, as it’s no worse than having two mortgages and another loan – which would likely have higher interest rates.
Your Home Equity Loan Interest Payments Will Likely Not Be Tax-Deductible
In 2018, changes to tax codes led to somewhat ambiguous guidelines for investment properties. Because of this, we recommend consulting with an accountant before making any decisions. However, if the home equity loan is not specifically being used to improve the property it was taken out against, it’s likely it will not be tax deductible.
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Taking Out A Home Equity Loan To Buy Another House: FAQs
To fund a property purchase, should I get a lump sum home equity loan, HELOC or a cash-out refinance?
As opposed to the one-time, lump sum payment received through a home equity loan, HELOCs, or home equity lines of credit, function similarly to a credit card, as they allow you to access and utilize the equity as you choose – up to a certain limit and within a certain time frame. Although HELOCs can offer more flexibility than home equity loans, they also come with higher closing costs and variable interest rates, which may mean paying more over time. Rocket Mortgage does not offer HELOCs.
Another option to consider is a cash-out refinance, which allows you to take on a larger mortgage in exchange for accessing equity in your home. Because it’s a form of refinancing and not a second mortgage, a cash-out refinance doesn’t add to your monthly payment and instead extends the length of the original loan.
There’s a lot to consider when choosing between a HELOC and a cash-out refinance, but if you’re planning to use your money as a lump sum as you would with a down payment, a cash-out refinance or home equity loan will probably make more sense.
When can I sell my house after I take out a home equity loan?
There’s no set time limit for how soon you can sell your house after taking out a home equity loan. However, in any mortgage transaction, paying off liens is necessary to sell the property. This is due to the fact that your home is held as collateral on the loan, but it doesn’t mean you have to wait to sell.
If you choose to sell your house while still making payments toward your primary mortgage and home equity loan, you will be able to pay off these liens from the home sale’s proceeds. For example, if you sell your home for $350,000 while owing $150,000 on your mortgage and $50,000 on your home equity loan, that money due will be deducted from your home’s sale, leaving you with $150,000 in profits.
Will a home equity loan put my mortgage underwater?
An underwater mortgage is a home loan with a higher principal than the home is worth. This typically occurs when a property’s value falls while the homeowner is still repaying the original balance of the loan. Although it’s not likely that a home equity loan will directly lead to an underwater mortgage, you will be at a higher risk due to owing more on the property.
What other investment property or second home property financing options are available?
Alternate forms of financing for purchasing a second home include:
- Private money lenders
- Peer-to-peer lending
- Self-directed IRAs
The Bottom Line: Taking Equity Out Of Your Home To Buy Another House Comes With Risks, But It’s A Solid Option
Can you use home equity to buy a second home or an investment property? The answer is yes – and there are some significant benefits to doing so. But like with any new debt, there are also some potential risks. To ensure your financial success, we recommend analyzing all of the pros and cons before taking action.
If you’re interested in accessing your home’s equity or lowering your mortgage payment, visit our Learning Center to learn more about the refinancing process.
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