Using Home Equity to Buy Another Home

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Buying a second home is risky business. At least that’s what the lenders think. They know your priority is on your first home. If you run into financial trouble, you would be more likely to let your second home go. That being said, lenders often have stricter guidelines for a mortgage on a 2nd home. One way around it is by using the equity in your current home.

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Tapping Into Your Home’s Equity

If you have sufficient equity in your primary residence, you may tap into it. This is often the desired route for many reasons:

  • Interest rates are lower
  • Qualifying is easier
  • Closing costs are lower
  • Tax deductions may be higher

A 2nd mortgage historically carries lower interest rates than 1st mortgages. This is especially true for a 1st mortgage on a second home. Again, because the loan affects the home you live in, you are likely to pay it. A mortgage on a 2nd home is easier to let go. Taking out a second mortgage allows you to take advantage of these low rates and still buy the home you want.

Home equity loans or HELOCs usually have more flexible requirements than a second loan. Again, it’s because of the risk level. If you take out a HELOC or 2nd mortgage with your current lender, you may have even less to verify. Either way, qualifying for both loans is more relaxed than qualifying for a 1st mortgage on a non-primary home. You’ll get higher LTV and debt ratio allowances and possibly lower credit score requirements.

Second mortgages don’t have many closing costs either. Because they are less work, they don’t require the hefty fees you might pay on a 2nd mortgage. Borrowers avoid paying for title searches and/or insurance. They also don’t have to pay very high processing/underwriting fees. Lenders often charge one flat fee on HELOCs. Of course, you can always shop around to find the lowest closing costs as well.

Lastly, you may be eligible to deduct the interest on your HELOC. Usually borrowers can only deduct the first $100,000. But, if you use the equity to purchase a home for residential use, you can deduct interest on loans up to $1,000,0000 combined.

HELOC or Home Equity Loan?

Now the big question is whether you should take out a HELOC or home equity loan. First, let’s look at the difference.

  • HELOC – You get a line of credit with this loan. You take the cash as you need it. If you purchase a home, you’ll likely need all or most of it. You then pay interest on that amount for the draw period (usually 10 years). After that 10 years, you pay principal and interest. You can no longer draw during the repayment period. The key is you can use the funds repeatedly. If you repay the principal, you can continue to use it during the draw period.
  • Home Equity Loan – This is a 2nd mortgage and it works a little different. You get one lump sum payment at the closing. Once you use the funds, they are gone. You can’t repay the principal and reuse the funds. You pay principal and interest starting with your first payment.

Which loan is right for you? Consider the home you want to buy. Is it ready to live in? Does it need fixing up? This usually helps determine the right type of loan. A home that needs fixing up usually does better with a HELOC. This way you always have a credit line available for you if something comes up. Of course, you can’t go above your credit limit, though.

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If the home doesn’t need repairs or remodeling, a home equity loan might suffice. This way you don’t have access to any more funds. You buy the house and pay the loan off. You start paying principal and interest right away. This helps you own more in your primary home faster as well as own your second home outright.

Watch Out For Tax Issues

What do you plan to do with the home? Is it a vacation home or second home? If so, you shouldn’t have any tax issues. You can deduct the interest as we discussed above. Of course, you should always talk to your tax professional first.

However, if you use the home for rental purposes, you may have some tax issues. Right now, the IRS allows you to rent a home out for up to 14 days per year without tax implications. Beyond that 14 days, though, you must claim the rental income. This could take away from your tax deductions and become a liability for you. Knowing this ahead of time can help you make the right decision.

The Bottom Line

Essentially, you must decide why you want a second home. Are you trying to make money? Is it an investment? Or do you want a second home to enjoy in your favorite spot? The use will help determine how you should pay for it. It will also help you gauge your future liabilities.

Common choices are the home equity loan and the HELOC. Of course, this only works if you have the equity in your primary residence. Many people make this decision once they pay their primary home off. Owning it free and clear gives them the opportunity to buy another home for vacation purposes.

Talk to several lenders about your various options. See what interest rate adjustments they may impose on you and compare the closing costs. As always, before you apply, check your credit and other qualifying factors. If you have late payments or a low credit score, fix it. Lower your outstanding debt and pay your bills on time. Keep your debt ratio low and make sure your employment history is consistent. These are the best ways to maximize your chances of approval on any type of second mortgage. Then you can enjoy the benefits of owning more than one home.

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