Exploitable home equity is now at an all-time high – Black Knight estimates the average homeowner is sitting on $185,000 of net worth – and mortgage rates, while up a bit, are still near historic lows (although many pros are predicting it will increase further in 2022). This leads some homeowners to wonder: can I use home equity or HELOC to pay for a second home here? Here’s what you need to know first, and you can see the latest home equity rates and HELOC rates you are eligible for here.
You can use a home equity loan or HELOC to help you buy a second home
Homeowners with excess equity in their primary residence looking to buy a second home can use a home equity loan or line of credit to do so, says Greg McBride, chief financial analyst at Bankrate.
Because interest rates on second homes are often higher than mortgages for primary residences, Holden Lewis, home and mortgage expert at NerdWallet, says that if you can get a loan against the equity in your primary home at a lower interest rate, then it might be a good idea to finance your second home this way — or at least to finance the down payment. And McBride adds that using home equity can work especially well if the second home is something like a small vacation home or cottage where getting a mortgage may not be cost-effective or feasible. But “before you take the plunge, talk to an accountant to understand how this will affect your tax deductions. You may find that you’ll get better tax treatment by using a standard mortgage to buy the second home,” says Lewis.
Using a home equity loan can be beneficial for a down payment if you are buying a second home in a highly competitive area and need to compete with all cash buyers (you can see the latest home equity rates and HELOC rates you are eligible for here). Efficient use of equity makes a buyer more attractive because they are able to put money aside and increase their buying power. Additionally, home equity loans tend to have lower interest rates than many other types of loans, which means they can be a more affordable way to borrow funds.
That said, some lenders may be wary of down payments funded by home equity loans or HELOCs. And to qualify for a second home mortgage, lenders typically require a debt-to-income ratio (DTI) of 43% or less — so more debt on your balance sheet may not work in your favor. To calculate your DTI, add up all your monthly debts and divide the total by your gross monthly salary.
Cautions About Using a Home Equity Loan or HELOC to Help Buy a Second Home
Opting for a home equity loan or HELOC comes with some caveats. If you are home rich and cash poor and you become unable to make a payment on your loan, the lender may foreclose on your home. Additionally, in many cases, borrowers can only access 80-85% of the equity in their primary residence, which is also true for HELOCs. For example, if your home is worth $400,000 and you owe $300,000, you have $100,000 of equity of which you could borrow $85,000.
As with other types of loans, home equity loans are subject to fees such as closing costs, which typically range from 2% to 5% of the loan amount – which is why it may be beneficial to speak to a planner or a financial adviser about the pros and cons unique to your situation.
Is another method of financing a second home better than a HELOC or home equity loan?
Mortgage rates on second homes tend to be higher than primary homes, but for buyers with a healthy down payment, the markup can be minimal, which would make a traditional mortgage the more attractive route. McBride said.
Additionally, if you’re buying a second home to generate income, McBride says, “Investors buying rental property often choose to finance it directly and separate it from their primary residence for tax or liability purposes.”
On the other hand, using an equity loan to buy a second home has advantages such as making your offer more competitive and increasing your chances of approval, as using equity can be considered as less risky for lenders, given the collateral involved.
How to Get a HELOC or Home Equity Loan
Even if you have good equity in your primary residence, approval for a home equity loan is not solely dependent on the amount of equity available. Lenders consider credit scores, income, and other debts owed when determining how much loan they will provide. To ensure a timely transaction, it is wise to preemptively gather documentation showing your household income using pay stubs or W-2s, a property tax bill, a copy of your home insurance and your personal financial statements. It’s also essential to shop around with different lenders, including whoever holds your current mortgage as well as the banks where you hold accounts.