Using Home Equity for Down Payment on a Second Home
We have included below a recent article from Lending Tree on using home equity to purchase a second home. We have helped a number of clients think through the advantages and disadvantages of a second home, thinking through not only the financial aspects of this decision but also non-financial aspects of owning a second home. Ed Schmitzer shares some planning thoughts in the article as well. The author of the article is Laura Woods. You can find the original article here.
Purchasing a second home to rent as an investment property or to enjoy as a home away from home requires a significant amount of cash. But if you have equity in your primary residence, you might be able to leverage it for the down payment on a second home. Learn more about this process, so you can decide if it’s the right move for you.
Using home equity for a down payment: How it works
A home equity loan and a home equity line of credit (HELOC) are two common ways to obtain home equity financing. If you choose a home equity loan, you’ll receive a fixed amount of money upfront and repay it in equal monthly installments over a set period of time. Conversely, a HELOC serves as a revolving line of credit, granting you access to as much money as you need, when you need it, as long as you don’t exceed your credit limit. You only make payments for the amount of credit you actually use.
How much can you borrow?
Dennis Nolte, a financial planner at Seacoast Bank in Winter Park, Fla., said the amount of home equity you can borrow varies by lender.
“If the lender is allowing 100% loan-to-value, the owner can borrow all the equity out of the residence,” Nolte said. “Some lenders require an 80% LTV, some 90%.”
For example, if your primary residence is valued at $300,000 and you owe $200,000 on it, an 85% LTV would work like this:
- 85% of the $300,000 home value is $255,000
- Mortgage balance is currently $200,000
- $255,000 minus $200,000 equals $55,000
- Therefore, you would be allowed to borrow up to $55,000
The LTV attached to the home equity loan or HELOC can play a key role in your ability to use it for a down payment on a second home. In most cases, you’ll need a 15% to 20% down payment for a single-family home you don’t plan to live in. (Note: Qualifying for a 15% down payment generally requires borrowers to have a credit score of 720 or higher.)
The down payment requirement typically increases to 25% for a multi-family unit you don’t plan to reside in. On the other hand, if you want to live on the property, you might be able to purchase a two-unit primary residence with a 15% down payment or a three-to-four-unit primary residence with a 20% down payment.
What are the costs?
Similar to a first mortgage, Nolte said home equity loan closing costs range from 2% to 5% of the loan. He said this includes charges for services like an appraisal, title search, document preparation and other underwriting costs.
Nolte said a HELOC generally has few closing costs, often limited to an appraisal and document preparation. Despite this, it’s important to shop around to find the best deal because some lenders have more fees than others.
The Federal Trade Commission warns that your HELOC lenders may charge closing costs like an application fee, title search, appraisal, attorney fees and points. You could also be charged with continuing costs, such as an annual membership or participation fee and/or a transaction fee every time you borrow money. Consequently, the FTC recommends negotiating with lenders to try and reduce or eliminate these expenses.
Then there’s the interest rate.
Marguerita Cheng, CEO of Blue Ocean Global Wealth, an investment advisory firm in Gaithersburg, Md., said most HELOCs have a variable interest rate, meaning your payment could go up.
“It’s important to ask that question,” she said. “What’s the maximum this could reach?”
She noted that a rate on a home equity loan is going to be higher than a line of credit because the loan does not adjust.
“You’ve got to make sure you can qualify for that loan and pay off that loan,” she said.
Expert advice to choose the best financing for you
Nolte shared several questions to ask yourself before deciding whether to use home equity for a down payment on a second home, including:
- Are you maintaining 20% equity in your home to avoid PMI costs?
- Can you cover the debt on both homes if you have no renters in the second home, if real estate prices drop or if you can’t sell the second home (if you’re planning to fix it up and flip it)?
- Is there a prepayment penalty on the home equity loan or an early closure fee on the HELOC?
After answering these questions, think about the bigger picture.
“When purchasing a property, look at the overall impact on your situation,” Cheng said. “You don’t want to withdraw so much that it puts you in a higher tax bracket.”
She advised researching your property value, seeing how much you owe, monitoring rates and comparison shopping before choosing to finance.
“Every situation is unique,” Cheng said.
She also recommended looking into any special home equity offers promoted by financial institutions, like lender-paid closing costs.
Pros of tapping home equity for a down payment
- You’re able to retain cash reserves for emergencies.
- It offers the potential to make a large down payment.
- “You’re using assets from the same asset class — real estate to real estate — and not sacrificing opportunity cost of other assets’ appreciation,” Nolte said.
- If you choose a home equity loan, the rate is fixed, which Nolte said is a good thing in this environment.
- HELOCs offer flexibility with borrowing amounts and you don’t pay interest until you access funds.
Cons of using home equity for a down payment
- You’re putting your primary home on the line for a second.
- You must pay interest on down payment — and it’s not tax-deductible.
- “The interest rate paid on the HELOC is probably higher than the rate earned on cash,” Nolte said. “The rate might be variable or fixed, and a variable rate in this environment is not prudent.”
- “If you want to refinance the loan on your primary residence it might take longer, or put the kibosh on it entirely, if there is a second lien,” Nolte said.
- HELOCs and home equity loans often have fees and penalties that can significantly increase the price of the loan.
Can you afford two mortgages and a home equity loan?
You might be able to secure the funding for two homes, but Ed Schmitzer, president and founder of River Capital Advisors, an investment advisory firm in Jacksonville, Fla. advised adding up all the costs associated with acquiring an extra residence.
“Owning two homes doubles the costs for the family — two utility bills, two real estate tax bills, furnishings for two homes, insurance, etc.,” Schmitzer said. “Also, my experience has been that people overestimate how much they may use a second home.”
Generally, when he talks to clients about purchasing a second home, Schmitzer said he recommends setting money aside and using it to rent a place instead of buying it, to see how long the funds last. He also asks clients to add up all the additional costs to operate a second home and compare it with usage to see if it makes financial sense.
Considering the impact the second home will have on retirement savings and education funding — if applicable — is also important, Schmitzer said.
“Sometimes the client talks about renting the property to help pay for it,” Schmitzer said. “Putting income tax issues aside, [a] rental property is like a business and it needs attention — tenants [leave], repairs are needed or the property is not always rented.”
If you’re renting a property you also want to use as a vacation home, he said to consider how you’ll enjoy it if you’re sharing with a tenant.
“Will having someone else living in your home be a problem?” he asked. “There are hassle factors to being a landlord.”
Before making a decision, take all costs into consideration. The last thing you want is a second home to impede your quality of life or put you at risk of losing your primary residence.
Other down payment options
Besides a home equity loan or HELOC, there are a few more ways you could go about getting a down payment for a second home.
Effectively replacing your existing mortgage, a cash-out refinance allows you to take out a new mortgage worth more than your existing loan. You’ll pay off the first mortgage with the funds, then receive the difference in cash. The new mortgage may have a different interest rate and different terms than your current one.
Using home equity isn’t the only way to finance a down payment on a second home. If you are unable or unwilling to take this route, consider these alternatives.
Relocate to a multi-family property
If you don’t have much home equity to work with and are set on having an income property, you could go the owner-occupied route. You can get an FHA loan with a down payment as low as 3.5% on property with up to four units, as long as one serves as your primary residence.
Borrow from retirement accounts
It’s a risky option, but you could take out a 401(k) loan for down payment funds. You can read more about the advantages and disadvantages of this option here.
Wait till you have the cash
If you don’t want to or can’t leverage your home equity for a down payment on a second home, you may want to go the traditional route of saving up for it. You could expedite the process by taking on a side gig or selling possessions you no longer need.
The article above was shared with permission of the author.