Financing a Second Home? Use a Home Equity Loan
Buying a second home can pose some challenges you don't face when buying a home for your primary residence. The mortgage interest rates are higher. Lenders will scrutinize your credit reports and income documentation very closely to ensure you have sufficient income to meet all your obligations. The property itself may be difficult to qualify for a mortgage.
However, if you have a good credit score and your primary residence is a valuable first property to use as collateral, using a home equity loan to make the purchase may be an easier less expensive and speedier process than opting for a traditional mortgage loan.
The challenges of buying a second home
Second homes can be difficult to get financing for, particularly if they're vacation properties. If designed for seasonal use, they may lack features that lenders will insist on, such as central heating. Or they may be built on leased land, or have tons of association restrictions on property transfers that can scare lenders off.
Lenders also know that when times get tough, borrowers are likely to cease making payments on a second home before they do so on their primary residence. That represents added risk, meaning a higher interest rate and tougher eligibility standards for a mortgage to buy such a property.
Advantages of Home Equity Loans
A home equity loan can be a good solution here. A home equity loan is secured by your primary residence, so as far as your lender is concerned, the second home doesn't even enter the picture. All they care about is whether your credit, income and primary residence can support the loan - you can do whatever you want with the money.
The interest rate on a home equity loan may be lower than on a mortgage secured by a second home, because the lender knows you've got a stronger commitment to your primary residence. And just as with a regular mortgage, the interest paid on a home equity loan is tax-deductible. Not only that, but since you're using it to purchase a residence for your own use, the usual $100,000 cap on tax-deductible home equity debt is lifted - instead, you can deduct the interest paid on up to $1 million in mortgage debt combined for both homes.
By using a home equity loan, you may be able to avoid some of the closing costs associated with originating a completely new and separate mortgage. If you do a little homework and crunch the numbers, you may discover that a second home is less expensive than you thought, and comes with interesting perks.
You can also avoid some of the fees associated with a regular mortgage, such as title searches or insurance.
Of course, to use a home equity loan to buy a second property, you need to have substantial equity in your current home. Generally, lenders will allow borrowers with good credit to borrow up to 85 percent of the current value of their home, less whatever you owe on any other mortgage secured by that property.
So if you have a $400,000 home and still owe $200,000 on the mortgage, you could buy a $140,000 vacation home using a home equity loan on your primary residence ($200,000 $140,000 = $340,000, or 85 percent of $400,000).
Second Home for Income Production
A second home can actually help you earn extra income. One of the best benefits is that you can rent out your second home to tenants when you're not using it as a vacation property for your own family.
If you use the property less than 14 days a year, or 10 percent of the time it's occupied, you can declare it an investment property, which allows you to deduct such things as maintenance costs, depreciation and the like. The rent can even cover the payments on the home equity loan you used to purchase it.
Even if you use if for more than 14 days or 10 percent of the time it's occupied each year, you can still deduct a proportionate amount of your expenses for the property, per IRS rules.
If you buy from someone who rented or leased the house for profit, you can prepare a financial statement based on the past income history of the property and show it to your lender. By reviewing the records, a bank or mortgage company will see that the property will probably not be a financial liability, but may actually add extra net income to your bottom line.
You may also want to hire a professional appraiser to do an objective market analysis of the property. By comparing it side-by-side to similar income-producing properties in the same neighborhood, an experienced appraiser can ascertain a home's future income potential with remarkable accuracy.
If you're fortunate enough to be able to afford a second home, you're smart enough to investigate a variety of ways to pay for it. A home equity loan may be the most intelligent way to go. To paraphrase an old expression, "Home is where the equity is."
Purchasing a second home is always going to be an investment and you have the option to rent it all year round or when not being used. Home equity loans have lower interest rates than a regular mortgage.
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