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Using A Home Equity Loan To Buy Another House: What You Should Know

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Published on October 26, 2022
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Homeownership can be costly and stressful, but it also brings a host of advantages. A primary perk is equity, or the amount of value you build in your home as you pay your mortgage.

Equity can become cash you use for numerous purposes, such as a home equity loan to buy another house. If you’re looking for a way to fund your purchase of a second home or investment property, a home equity loan might be the solution. Consider the following details, with the pros and cons, before using a home equity loan to purchase property.

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Can You Use A Home Equity Loan To Buy Another House?

A home equity loan allows you to borrow against the equity in your home and use the money for any purpose. Because home equity loans give access to potentially hundreds of thousands of dollars, homeowners can use them to finance the purchase of a second house.

For example, if you have a $250,000 home and have $25,000 left on your mortgage, a home equity loan will allow you to access about 80% of your equity – in this scenario, that’s $180,000. As a result, home equity is a powerful financial tool that can enable you to make substantial purchases, even if you don’t have a large bank account balance or other assets.

A home equity loan becomes a second mortgage you pay monthly, like your original mortgage. You can use the cash from a home equity loan to finance purchasing a vacation home or investment property.

The Pros And Cons Of Using Your Home Equity To Purchase A New Home

Home equity can help you afford expensive purchases. However, it’s wise to thoroughly weigh the advantages and disadvantages of using a home equity loan before buying a second home.

Pros 

  • Home equity funds can cover the cost of a down payment involved in a home purchase.
  • If you have enough equity (usually in the hundreds of thousands), you can buy a home solely with cash.
  • Home equity loans have lower interest rates than other types of loans. The rate is also usually fixed.
  • Lenders have less stringent requirements than with other types of home loans.
  • You receive funds as a lump sum instead of installments so that you can use the value of your equity instantly.

Cons 

  • A home equity loan creates a new mortgage, meaning you’ll have to budget for two monthly payments.
  • Higher interest rates than the initial mortgage loan.
  • Carrying a home equity loan can hurt your credit score, reducing your ability to refinance an existing home loan.
  • Home equity loans entail closing costs of 2% – 5% of the loan amount.
  • Your home is collateral for the loan, meaning that you could lose your home if you default.

The Pros And Cons Of Using Your Home Equity To Buy A Rental Property

Buying an investment property with a home equity loan has distinct advantages and disadvantages. Because rental properties have financial implications from first or second homes, consider the following if you plan on investing in real estate using a home equity loan:

Pros 

  • It’s an excellent option for funding a real estate investment business because it gives you access to vast amounts of capital at a low interest rate.
  • Rental income returns can help pay off the home equity loan faster.
  • Costs associated with renting property are usually tax deductible.
  • It can reduce the need for additional investors by allowing you to make a sizable down payment or purchase the property outright.

Cons 

  • It could take a while to make a profit significant enough to help with your mortgage payments.
  • A home equity loan will increase the business’s debt burden.
  • Using a primary residence as collateral for a business means risking foreclosure if you can’t keep up with payments. In essence, you are turning one of your primary assets (your home) into a financial burden.
  • Your equity limits the loan amount, meaning you may have to seek additional funding sources if you don’t get enough money from the loan.
  • If the housing market takes a dive, it may be challenging to sell or rent your property for a profit.
  • Interest payments are not tax deductible when you use a home equity loan for an investment property.

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Alternatives For Using Your Equity To Buy Another Home

As with any loan, home equity loans come with benefits and drawbacks that might affect your financial situation. However, numerous financial instruments can help you leverage your equity for a home purchase. So, it’s a good idea to assess the following alternatives when deciding how to use your equity:

Cash-Out Refinance

A cash-out refinance allows homeowners to receive a new loan in place of their original mortgage plus cash for their equity. For example, if you have $75,000 remaining on a $150,000 home, you could use a cash-out refinance for a new mortgage of $125,000 and obtain $50,000 minus closing costs and fees. This lump sum can become a helpful down payment on a new property.

It’s recommended to consider the pros and cons of a cash-out refinance versus a home equity loan. Both can have fixed, low interest rates, and borrowers receive lump sums from both loan types. However, while cash-out refinances might have higher closing costs, they leave homeowners with a single mortgage payment and typically have lower interest rates than home equity loans.

Personal Loan

Homeowners can also use an unsecured or secured personal loan to cover the costs of buying a home. Personal loans range in amount and can be $100,000 or more. As a result, they can accomplish the same purposes as a home equity loan.

You can get a personal loan with or without collateral by applying with a lender. You’ll need a solid credit score, and it’s a good idea to shop lenders to generate options. Once you pick a lender, you’ll submit your income, employment and housing information. If the lender approves the loan, you’ll receive the funds in a lump sum.

Personal loans come in secured and unsecured forms. An unsecured personal loan requires no collateral but will have a higher interest rate or shorter term. On the other hand, a secured loan requires collateral, such as an investment account or other asset. The borrower risks losing the collateral if they fall behind on the loan but receive better terms in return.

Reverse Mortgage

Retirees aged 62 and up can get a reverse mortgage on their primary residence. This financial tool pays off your mortgage if you have one and returns your equity as monthly installments, a lump sum, a line of credit or a combination of the three.

Because reverse mortgages are similar to home equity loans, you’ll have to decide between the two. A reverse mortgage involves origination fees, upfront and annual mortgage insurance premiums, and appraisal fees, so it might be more expensive than a home equity loan.

On the other hand, you won’t have to repay a reverse mortgage until you move. If you pass away, your heirs will be responsible for the mortgage. As a result, a reverse mortgage may present less of a financial burden. However, it’s best to compare interest rates, loan terms and monthly payments to determine which is best for you.

Cash Savings

If you have sufficient liquid assets in a savings or checking account, you could use them to cover the down payment and closing costs or fund the entire purchase of a second property. In addition, money market accounts, mutual funds, stocks, and bonds are liquid assets. However, if they reside in a retirement account, such as an IRA or 401(k), you’ll incur heavy tax penalties for touching them before retirement.

Home Equity Line Of Credit (HELOC)

A home equity line of credit (HELOC) gives a homeowner a line of credit based on their equity. Instead of a lump sum, you can draw on your equity, repay it, and borrow it again for a specified amount of time known as the “draw period.” In essence, you turn your equity into a credit card for 5 – 10 years, after which you repay the balance in installments plus interest.

Because a HELOC uses your equity, you’ll likely decide between that and a home equity loan. The benefits of using a HELOC versus a home equity loan include the following:

  • Payments for HELOCs aren’t due until the draw period expires. However, homeowners might pay interest on the amount borrowed during the draw period.
  • Repayment for home equity loans lasts between 5 and 30 years. HELOCs usually have a fixed structure of a 10-year draw period and 20-year repayment period, giving you ample time to borrow and repay.
  • Variable interest rates on HELOCs can be lower than the fixed rates of a home equity loan.

Hard Money Loan

A hard money loan uses the borrower’s home as collateral. In addition, these loans typically come from private lenders instead of conventional banks or credit unions. A hard money loan gets a lump sum to the borrower quickly, and the borrower usually pays back the loan in 3 years or less. The risk of a hard money loan is foreclosure if you can’t make loan payments.

FAQs About Getting A Home Equity Loan To Buy Another House

Home equity loans are complex, and you can learn more about how to use them through the following frequently asked questions:

How can I figure out the amount of equity I have in my home?

You can calculate how much equity you have in your home by subtracting your mortgage balance from how much your home is worth. For example, if you have $100,000 left of your current mortgage and your home is worth $250,000, you have $150,000 of equity.

Remember, equity is not based on what your house appraised for when you purchased it. Instead, you weigh your mortgage against what the market determines your home is worth. As a result, how your home’s value has changed over time also influences your equity.

How can I buy another house with a home equity loan?

Use the following steps to secure a home equity loan and buy a second house:

  1. Calculate the equity and loan amounts. It’s wise to determine how much equity you can use and how much house you can afford before applying.
  2. Get prequalified. This step gives you crucial information early in the process. You’ll see your prospective interest rate and monthly payment amount by getting prequalified and receiving a Loan Estimate.
  3. Compare rates. It’s always a good idea to shop around. By comparing loan estimates between a few lenders, you can choose what fits you best: the lowest interest rate, longest term or reduced closing costs.
  4. Submit an application. Once you’re satisfied with a loan estimate, apply for initial approval with a specific lender.
  5. Use the lump sum to purchase a home. It generally takes two to four weeks to receive the loan funding from the day you apply. You can take advantage of the time by starting your house hunt during the waiting period.

Should I use a home equity loan to invest in a real estate investment trust (REIT)?

While you can use home equity loans for any purpose, such as investing in a real estate investment trust (REIT), it’s only wise if it’s likely that your return on investment will outpace the costs of the loan, such as interest and closing costs. REITs are investment portfolios comprised of real estate, and they have outperformed the S&P 500 by about 300% over the last two decades. They accrue earnings through collecting rents and capitalizing on property value increases.

However, all investments have risks. As a result, it’s recommended to calculate whether your annual dividend payments will outweigh the monthly cost of carrying a second mortgage. For example, the federal government taxes REIT dividends at higher rates than other investments. In addition, even if you do your due diligence, your investment could go south, leaving you with fewer assets and more debts. Therefore, using home equity loans for REIT investments could result in a poor investment and an unaffordable second mortgage.

Consult a qualified financial advisor before making a risky decision like this.

The Bottom Line

Homeowners can use a home equity loan to purchase an investment property or second home. Home equity loans can provide you with sufficient capital for a large down payment or the cash purchase of a property. Additionally, they have lower interest rates than other loan types.

However, home equity loans create a second mortgage you must pay monthly. As a result, your home becomes collateral for your loan, putting you at risk for foreclosure. Also, smaller amounts of equity may limit your financial capabilities and force you to look elsewhere for more funding.

Ready to start your journey to buy a second home or investment property? Apply for a home equity loan today.

Apply for a mortgage today!

Apply online for expert recommendations with real interest rates and payments.

Start Your Application
Headshot Ashley Kilroy

Ashley Kilroy

Ashley Kilroy is an experienced financial writer. In addition to being a contributing writer at Rocket Homes, she writes for solo entrepreneurs as well as for Fortune 500 companies. Ashley is a finance graduate of the University of Cincinnati. When she isn’t helping people understand their finances, you may find Ashley cage diving with great whites or on safari in South Africa.