Using Your Home Equity To Purchase a New Home

How to tap into your home's equity to buy an investment property

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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. 

Key Takeaways

  • Home equity can be a great source of funds when you need a large, lump sum of cash, such as 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's risk involved whenever you're 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.

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 your 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's value. This takes both your first loan and any subsequent ones into the calculation.

You could take a home equity loan of up to $140,000 if your home is worth $400,000 and your first mortgage balance is $200,000: $200,000 + $140,000 = $340,000, which is 85% of the home's value.

On the plus side, you’ll have fixed monthly payments over the life of the loan so there are no big rate increases to worry about. And 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 a refinance because 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 Tiffany Brown, broker-owner and loan originator with Motto Mortgage Summit in Castle Rock, Colorado. 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 you're usually looking at a lower loan amount,” Brown said.

On the positive side, closing costs for HELOCs are usually much less than those for 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 you'll hopefully have either a rental income stream to cover it or you might have resold the home for a profit by the time the full repayment period begins.

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, it could make for a sizable addition to your monthly expenses when the repayment period begins.

Cash-Out Refinance

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 you can net from the cash-out refi,” said Brown.

When interest rates are low, 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 are a lot of factors to look at when determining which way to go.”

A cash-out refinance is a more involved application process than a HELOC or home equity loan because 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 Mortgage

Reverse mortgages have a lot of complex rules and requirements, but it's actually possible to use this product to buy a new home. Homeowners who are age 62 or older can apply for a Home Equity Conversion Mortgage (HECM) for Purchase, but there’s a catch. The home that's purchased must be used as the primary residence. You can't use an HECM to buy an investment or vacation home.

Pros and Cons of Using Home Equity To Buy Another Home

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. But any time you use your home as collateral, you should think it through carefully.

Pros
  • Lower interest rates

  • Easy to qualify

  • You can preserve your other assets

  • Can create an income stream

Cons
  • Increases your debt burden

  • Your plans for your first home might not work out

  • Extends your loan burden

  • Risks your home

Pros Explained

  • Lower interest rates: Mortgage rates on investment properties are higher than they are for a primary residence, said Brown. “So if you have a significant amount of equity, the rates are going to be lower if you're borrowing against your primary home,” she said.
  • 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 because 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 you're pursuing an investment property.
  • Create an income stream: You can potentially see a return on your investment if you rent the second home or decide to fix it and flip it.

Cons Explained

  • 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.
  • Your plans might not work out: It could impact your finances if you're planning on renting out the second property or flipping it for resale and that plan falls through.
  • Extending your loan burden: You’ll likely be starting over with a 30-year mortgage if you do a cash-out refinance. Home equity loans and lines of credit can last for a number of years as well.
  • Risking your home: You're taking a gamble whenever you borrow from home equity. You could end up with very little equity if property values suddenly drop. Plus you risk foreclosure if you have trouble making payments.

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. You’d get .06 or 60% if you owe $300,000 and your home value estimate is $500,000. This is called your loan-to-value ratio (LTV). Now subtract the LTV percentage from 100%, and that’s how much home equity you have. In this case, it would be 40%. 

How can you increase the equity in your home?

You can increase the equity in your home in one of two ways: Either you owe less, or you 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 your down payment was when you first bought the home, the longer it will take you to build equity. You'll be reducing the principal amount owed on the home with each mortgage payment you make. You'll increase your equity over time as your loan principal amount decreases. It can also accelerate the increase in your home equity when home values rise or if you make significant home upgrades.

Article Sources

  1. National Credit Union Administration. "Home Equity Loans & Lines of Credit."

  2. Consumer Financial Protection Bureau. "Can I Use a Reverse Mortgage Loan To Buy a Home?"