Using Home Equity to Buy a Second Home

Interested in purchasing a second home for vacation, rental, or investment purposes? You may be able to conveniently tap the home equity you’ve accrued in your primary residence to finance a second home.

But it’s important to understand the pros and cons of doing so, the forms of home equity financing available, the tax ramifications of using home equity to buy a second home, and alternative ways to fund a second home transaction.

Can You Use Home Equity to Purchase a Second Home?

Home equity is the difference between the appraised worth of your property and your outstanding balance owed to the mortgage lender. You may qualify for home equity financing if you have accumulated sufficient equity – meaning you owe at least 15% to 20% of your home outright.

That can come in handy for a variety of goals, including paying for home improvements, college tuition, a major event like a wedding, or even consolidating your debt. 

Your home equity can also be used to buy a second home: a property that, separate from your primary residence, can be used as a vacation home, rental, future retirement residence, or investment property.

Three common ways to tap home equity from your primary residence include a home equity loan, home equity line of credit (HELOC), or cash-out refinance (more on these three options later).

“Legally speaking, nothing is stopping you from using the equity in your primary residence to purchase a second home. But be aware that many lenders may balk at this arrangement, preferring that you take out a separate new mortgage loan on the second home rather than leveraging your primary residence twice in the form of a second mortgage on the primary residence,” explains Martin Orefice, CEO of Rent To Own Labs. 

Also, note that a second home must usually be occupied by its owner for a portion of the year. Residency/occupancy rules for second homes will vary depending on loan requirements and local regulations.

“Generally, second homes are not intended to be the primary residence and may have limitations on how long or little you can occupy it,” Alexander Suslov, head of Capital Markets for A&D Mortgage, LLC, says.

Home Equity Option #1: Home Equity Loan

A home equity loan is a second mortgage loan on your primary residence, usually with a fixed interest rate and over a term that can span from five to 30 years, for which you receive borrowed money in a lump sum payment at closing. 

“Using a home equity loan is usually cheaper than securing a separate new mortgage not tied to your primary residence, as mortgages on second homes tend to be more expensive with higher down payment requirements and higher interest rates,” says Orefice. “But the obvious risk with a home equity loan is that you have to put your primary residence up as collateral.

That means you could end up losing your primary residence if you default on the home equity loan.”

As with any of the three options listed here, you’ll also pay closing costs for a home equity loan – which can equate to 2% to 5% of your loan amount. You’ll also probably need to have earned at least 20% equity in your primary residence to qualify.

Home Equity Option #2: HELOC

Think of a HELOC as a credit card of sorts, wherein you can draw money (borrow) multiple times from a predetermined maximum amount available. With a HELOC, you don’t necessarily get a lump sum; you can draw from your revolving line of credit at times of your choosing during a set draw period (often 10 years).

As you pay off the amount you owe, your available credit gets renewed. This allows you to borrow from your line of credit again if needed, and you can borrow any amount you require during the draw period up to your credit limit. Once the draw period concludes, the repayment period (typically 20 years) begins.

A HELOC also works as a second mortgage on your primary residence; the latter will be used as collateral and can be foreclosed upon if you don’t repay your HELOC per the terms and conditions.

With a home equity loan, you typically have a fixed interest rate, which provides the peace of mind of predictable monthly payments. But HELOCs usually come with adjustable interest rates, so you may pay more in total interest on what you borrow than if you had taken out a home equity loan. 

Home Equity Option #3: Cash-Out Refinance

Instead of taking out a second mortgage via a home equity loan or HELOC, you could simplify matters by replacing your first mortgage on your primary residence with another, possibly larger mortgage loan and liquidating some of the equity built up in your property in the form of cash taken out at closing. You can then use that cash to claim a second home.

“You may pay a lower interest rate with this option, but you’ll pay closing costs and higher monthly payments on your primary mortgage loan,” Suslov adds. 

Depending on the term you choose for your refinance loan, you may also be extending the length of time it will take to repay your mortgage debt. That can result in paying a lot more in total interest over the life of the loan.

Pros and Cons of Using Home Equity to Buy a Second Home

If you need funds to purchase a second home, you can do a lot worse than tapping into home equity.

“Pursuing a home equity loan, HELOC, or cash-out refinance allows you to leverage your existing home equity and potentially build wealth through property appreciation and, if you choose, rental income,” says Joshua Haley, founder of Moving Astute in New York City. 

It can be relatively easy to qualify for a home equity financing product. That’s assuming you have built up sufficient equity and meet other lending requirements – including having a decent credit score (typically in the mid-600 range) and a preferable debt-to-income (DTI) ratio (often 43% or less).

However, a home equity loan, HELOC, or cash-out refi “can increase your overall debt and monthly mortgage obligations and pose financial risks if your property values decline or rental income on the second home is insufficient. And if you cash out too much equity, it can limit your ability to use equity for other purposes in the future,” cautions Haley.

Additionally, as mentioned, a cash-out refi, home equity loan, or HELOC is a form of secured loan financing. In other words, there’s a chance you could lose your primary residence if you fail to repay your debt. Some alternative financing options don’t put your home at risk. 

Good candidates for tapping their home equity to purchase a second home include those with significant equity accrued in their primary residence and borrowers with a steady income, favorable credit history, and manageable existing debts.

“You should also have a clear understanding of your goals and the ability to manage ongoing costs and responsibilities of owning a second home,” suggests Suslov.

Alternatives to Home Equity Financing

Instead of cashing out equity in your primary home, you could pursue other forms of financing to buy a second home. These include a:

• Traditional mortgage loan (separate from the mortgage loan on your existing primary residence)
• Personal loan
• Hard money loan
• Investment property loan
• Loan from a peer-to-peer lending platform
• Premature withdrawal from your IRA or 401(k) retirement plan
• Partnership with or loan from private investors, possibly including friends or family members

“Each of these choices has its own set of pros and cons and qualification requirements. It’s crucial to assess your eligibility based on your financial situation and long-term goals,” Haley advises.

Tax Issues to Consider

You may be able to deduct from your taxes some of the interest you pay on a home equity loan, HELOC, or cash-out refi if you qualify. But it’s best to consult a tax professional for specific advice and eligibility requirements.

“Be aware of local tax regulations, as well. Property taxes, transfer taxes, and local tax laws can vary, impacting your overall tax liability,” continues Suslov. “And if you plan to rent out your second home, you will need to understand the tax rules regarding rental income and expenses, which can get complicated.”

Key Tips for a Successful Second Home Purchase

To improve your chances of finding, funding, closing on, and keeping your second home, follow these best practices:

• Set clear goals. “Determine your purpose for buying a second home – whether it is for personal use, rental income, or investment diversification,” Suslov suggests.
  
• Carefully research the area. “Familiarize yourself with the local real estate market, property values, and rental demand in the area where you plan to purchase your second home,” Haley says.
  
• Set a realistic budget for the second home transaction after pondering all related costs, including loan payments, homeowners insurance, property taxes, upkeep expenses, and utilities.
  
• Partner with trusted professionals. “Seek advice from a knowledgeable real estate agent, a skilled mortgage professional, and an expert financial advisor to ensure you make informed decisions throughout the process,” adds Suslov.
  
• Make contingency plans. Prepare for unanticipated costs, market changes, and possible fluctuations in rental demand.
  
• Know the local and legal rules and restrictions. “Familiarize yourself with local laws, zoning regulations, HOA rules, and any restrictions that may apply to your second home,” Suslov says.