Owning a second or vacation home is a dream for many, but getting a mortgage to buy one can be a challenge. The requirements can be significantly more stringent than those for a mortgage to buy a primary residence. An alternative possibility: tapping the equity in your current home instead.
There are three main options for using home equity to buy a second home. Each have their own requirements and restrictions, and an option that’s right for one family may not be best for another.
Home equity loans and home equity lines of credit (HELOCs) are usually used for smaller loans, such as pay for home improvements, but can be used for larger amounts as well. Cash-out refinancing, which also requires home equity, is the refinancing of a mortgage into a new one at a larger amount. The difference between the two mortgages is given to the homeowner in cash. All three options — home equity loans, HELOCS, and cash-out refis — can be used to buy a second home, provided you have enough equity.
These can be used to buy a second home, but not to buy a home to replace your current primary residence, at least not immediately. Cash-out refinancing and HELOCs generally require borrowers to remain in their primary homes for at least a year after taking out the loan. But buying a second home with the money is allowed.
Home equity loans and HELOCs
A home equity loan gives you a lump sum of money at a fixed rate of interest that’s typically higher than a HELOC, says Jon Giles, head of home equity banking for TD Bank in Charlotte, N.C. In addition to your regular monthly mortgage payment on your primary home, you’d make a home equity loan payment each month. HELOCs typically have few up-front costs. They’re a type of second mortgage, with the loan secured by a homeowner’s primary residence.
A HELOC is a line of credit you can make withdrawals from as you need the money. HELOCs are typically used for home remodels, and are also used for paying for college. Those are usually the best uses, Giles says, because they have long-term value, as opposed to short-term expenses like vacations.
“When you’re using the value of your home, what are the values to you?” he asks.
HELOC interest rates are typically adjustable and change as the prime rate changes. The interest rate will likely be higher than your first mortgage. HELOC rates could change as often as each month. That could give you a low monthly payment at first, and possibly higher payments later.
The draw period is 10 years, when you may only have to make interest-only payments, though you could pay back the principal also. The repayment period begins after those first 10 years, and can last 20 years. The repayment period will include the principal and interest.
While an excellent credit score of 800 isn’t needed to get a HELOC at the lowest rate available, a solid score of 660 or more will help. “You will get better pricing, based on the strength of your score,” Giles says.
The amount of equity you have in your home is another important factor in taking out a HELOC. The more equity you have, the more likely you are to be approved for this line of credit. A loan-to-value ratio, or LTV, of 80% or less is required, Giles says, meaning you have 20% equity in your home. A home equity loan and HELOC payment calculator can show you the payments for the loans.
Suppose you have $190,000 in equity in a house that’s currently valued at $275,000. You won’t get a check for all of that equity.
Lenders allow up to 80% of your equity to be taken out, so they’ll start by subtracting 20%, or $55,000 in this case, from the property value. That leaves $220,000.
Using a cash-out refi
While a home equity loan or HELOC allow repayment of the loan over years, a cash-out refinance requires paying off the existing loan before pulling out the equity in cash.
A cash-out refinance gives you a new mortgage to pay off the old one and withdraw the accumulated equity in cash. A single payment is made going forward, and a refi may be a chance to reduce your interest rate. However, if you extended the new mortgage terms beyond the years you had left on the original mortgage, you’ll be paying more interest over time.
In the above scenario of a home valued at $275,000, the existing loan of $85,000 would have to be paid off first in a cash-out refi. That would then leave a balance of $135,000, which is the equity that can be used as cash.
Like a HELOC, a cash-out refinance can provide a better interest rate than a home equity loan or even the first mortgage on a home. When interest rates are low, a cash-out refi can be worthwhile if the rate is lower than what you currently pay, and if you refinance for the same number of years left on the original loan.
While most lenders don’t charge fees for a HELOC, closing costs for a cash-out refi typically range from 3-6% of the loan amount, says Leo Loomie, senior vice president at Digital Risk, a Florida-based company that processes loans and works with the mortgage industry.
Tax issues to consider
Interest from cash-out refinance of an existing first mortgage is a tax deduction and can allow for more interest to be deducted as opposed to obtaining separate financing for the second home, Loomie says.
HELOCs are no longer tax deductible unless used for home improvement, he says.
However, if you use a HELOC on your primary home to buy a rental property, then you might be able to claim the interest under certain circumstances, says Beth Logan at Kolzog Tax Advisors in Chelmsford, Mass. Logan is an Enrolled Agent, which is a federally licensed tax professional with full rights to represent taxpayers before the IRS.
“But taxes are never that cut and dry,” Logan says. “There are details and intricacies making every situation different.”
“The vacation home rules on number of days rented, days available for rent, and days used by owners, relatives, and friends, make the vacation rental issues even more complex,” she says.