Buying a house with home equity: A smart idea?
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After years of making mortgage payments and building up equity in your home, you might wonder: Can I use my home equity to buy another house? In theory, you can — but it’s complicated, and it could be risky. Here are a few things to consider before tapping into your hard-earned equity to invest in more property.
Can you use home equity to buy another house?
Yes you can, hypothetically. In simple terms, home equity is the amount of your mortgage that you’ve paid off. It can be calculated by subtracting your outstanding mortgage balance from your home’s appraised value. Your equity in the home will increase over time as you continue paying down your mortgage (though you likely won’t see a real jump in equity until about 10 years into it).
Equity is a valuable asset for homeowners. If you need to, you can tap into your equity by applying for a home equity loan or a home equity line of credit (often abbreviated as HELOC). Borrowers often use these funds to finance a home improvement project, but the funds can be used for other things as well, including to purchase another property.
If you do decide to buy another house with funds from a home equity loan, here’s how it would work. Let’s say your current house is worth $400,000, and you’ve built up $150,000 of equity. Most lenders let you access up to 85 percent of your home’s equity, which means you could get up to $127,500 to put toward a down payment, closing costs and mortgage payments on a new home.
However, just because you can doesn’t mean you should. Why? For starters, these loans use your home as collateral, which means you could lose your home if you are unable to make the payments. In addition, a home equity loan is essentially a second mortgage on that home. If you use that money to purchase another home, that’s three mortgages you’re on the hook for each month. Remember, one day you may need the equity in your home for retirement, or an emergency, and you want it to be there when you need it.
Second home vs. investment property
There are different lender requirements and tax implications for second homes versus investment properties, so be clear about the purpose of a new property before you buy it. Each has its own unique financial considerations. Buying a second home with equity might mean getting a vacation house without having to dip into your savings, but unless you are making enough rental income on it to cover your costs, the additional mortgages can become financially draining over time. And mortgages on second homes and investment properties typically carry higher interest rates and require higher down payments.
If you do plan on renting the house out as an investment, be realistic about anticipated rental income. Don’t forget to factor in cleaning, repairs and a reasonable vacancy rate — and you’ll need landlord insurance too, which is more expensive than typical homeowners insurance.
Home equity loan vs. HELOC
Both home equity loans and home equity lines of credit (HELOCs) allow homeowners to borrow against their equity. But there are essential differences to bear in mind if you’re deciding between them.
With a home equity loan, you receive the funds in a lump sum, which you’ll pay back, with interest, over a set period of time. Home equity loans come with a fixed interest rate and fixed monthly payments, which makes them predictable and easier to budget for.
In contrast, a HELOC is not really a loan but a revolving line of credit — you can draw on the funds as you need to, and then pay them back, as many times as you like within the set draw period. HELOCs have variable interest rates, so your rate might increase or decrease (at preset times), making their payments less predictable. In addition, at the end of a HELOC loan term, any outstanding balance will convert to a permanent mortgage, so make sure you understand the conversion terms, interest rate and amortization period.
Pros and cons of using equity to buy another home
Consider these benefits and drawbacks before you decide to buy another house using home equity.
- You can finance a home purchase without tapping into your savings. This might be an attractive option if you want to reserve cash for a big expense (like college) or an emergency fund.
- You can make a large down payment on a new property. If you choose a home equity loan, you’ll get a lump sum. You can use those funds to make a substantial down payment, reducing your monthly mortgage payments.
- You can earn additional income. If you purchase an investment property, you could create a steady stream of rental income.
- You can borrow money at a more competitive rate. Because home equity loans are secured, meaning they’re backed by collateral, they generally have lower interest rates than other, unsecured loan types.
- You have to pay three mortgages. A home equity loan is basically a second mortgage. If you take one out and use the funds to buy another house, you’ll be responsible for three mortgages on just two properties. Plus you’ll have to pay closing costs on both the second mortgage and the new home’s mortgage.
- You put your primary home at risk. Collateral can be a negative as well as a positive. Since your home is the collateral on a home equity loan, you could lose it if you are unable to make the payments for any reason.
- If property values fall, you could owe more than your home is worth. This is known as an underwater or upside-down mortgage, and it makes it difficult to sell or refinance your home. The values of second homes in vacation areas can be particularly volatile.
- Your new interest rate will likely be higher than your existing one. Even though home equity loan interest rates are lower than unsecured loans, they’re usually higher than mortgage rates.
Tapping into your home equity to buy another house, whether it’s a second home or an investment property, can help you expand your real estate portfolio without draining your bank account. However, using your equity in this way has some serious drawbacks, and you should carefully consider whether or not you want to assume the risk and financial commitment of doing so. One way to help mitigate the risk is to fund a second-home purchase only partially with equity funds, not entirely: That way, if you need to liquidate the second home in an emergency, you could still realize enough cash from the sale to pay off your home equity loan.