Last updated: September 10, 2024
How to use your home equity to buy another house
In competitive real-estate markets, it is important to have easy access to funds while purchasing a second home. If you’re a current homeowner who’s thinking about buying another house, you may be wondering where you can get the cash to put toward your next home purchase. One financing option is to unlock a portion of your existing home equity and use it.
What is home equity?
Home equity refers to the portion of your home’s value that you own outright. For example, if the current market value of your home is $400,000 and you have a balance of $200,000 on your mortgage, then you have $200,000 in home equity. If you’re looking to purchase a second home, you may be able tap into a portion of this equity to receive cash for a down payment.
Homeowners can borrow against their home equity using a traditional home equity loan, home equity line of credit (HELOC), or even a cash out refinance. These borrowing options allow you to use your home equity as collateral for the loan, which may result in lower interest rate offers compared to other forms of borrowing like personal loans or credit cards.
Each type of home equity financing comes with unique features:
- Home equity loan: A home equity loan is a lump sum of money you can borrow, using your home as security. Home equity loans typically have a fixed interest rate and fixed monthly payments over a fixed term of 10-30 years.
- Home equity line of credit (HELOC): A HELOC is a line of credit with a monetary limit, which you can access as needed for a second home loan. There is a fixed draw period during which funds can be withdrawn. There is also a fixed repayment period that typically lasts from 10-20 years during which you finish repaying the loan. Since HELOC interest can sometimes be variable and dependent on national economic factors, monthly payments may fluctuate and may increase as the repayment period progresses.
- Cash out refinance: A cash out refinance involves updating your mortgage loan for a larger amount than you already owe. You can withdraw that extra money from your home equity as cash and repay it along with your mortgage in a single monthly payment. If you have a $100,000 mortgage and you want to borrow $50,000 to buy a second home, you could potentially refinance your original mortgage loan for the combined $150,000 to do so.
READ MORE: What is a home equity loan? How does it work?
Requirements for using a home equity loan to buy another house
There are several factors that lenders typically consider when determining whether to approve you for a home equity loan:
- Sufficient equity in your home: The first requirement for a home equity loan is that you have sufficient equity available in your home to draw from. Lenders typically assess your combined loan-to-value (CLTV) ratio to determine the amount they are able to lend to you. CLTV is calculated by dividing the total of your mortgage amount, the total of you new loan, and any additional loans that you have against your home by the current value of your home. If the current value of your home is $400,000 and your combined loans total $300,000, your CLTV is 75%.
- Credit score: Your credit score is another important factor that lenders consider when determining to approve you for a home equity loan — no matter if you’re using it for a down payment on another house, remodeling your current home, or using the cash for any other purpose. A higher credit score indicates to lenders that you are likely to repay your loan on time, and may result in lower interest rate offers.
- Debt-to-income ratio: Lenders will also look at your debt-to-income (DTI) ratio when considering your application for a home equity loan. Your DTI is calculated by dividing your monthly debt payments by your gross income. Lenders generally look for a DTI of 43% or lower, which means that your monthly debt payments should not exceed 43% of your gross monthly income.
- Proof of income: To qualify for a home equity loan, you’ll need to provide proof of income. This may include pay stubs, tax returns, bank statements, and other financial documents. Lenders typically want to ensure that you have a stable source of income and that you’ll be able to manager your loan payments.
- Home appraisal: In addition to assessing your personal financial details for your ability to repay, lenders will also require a home appraisal to determine the current value of your home. This will help your lender determine how much equity you have in your home and how much you may be able to borrow.
Depending the lender you work with and the type of home financing you select, specific details including available loan limits, CLTV requirements, and interest rates may vary. Research and compare the options that may be available to you when you’re looking for the product that will work best for your unique situation.
READ MORE: How to qualify for a home equity loan
Discover® Home Loans offers low fixed rates on home equity loans up to 90% CLTV with $0 application fees, $0 origination fees, $0 appraisal fees, and $0 costs due at closing.
Step-by-step: Use your home equity to buy another house
Using your home equity to buy a second house may be a smart financial move if you’re able to manage your debt and repay your loans on time. However, it’s important to carefully consider your financial situation and ability to repay before borrowing against your home equity. Here are a series of steps to achieve your homeownership goals by using your home equity to finance the purchase of another home:
Step 1. Calculate your home equity: The first step in using your home equity to buy another house is to determine how much equity you have in your current home. To get an idea of what options may be available to you based on your available equity and desired loan amount, try using a loan amount calculator.
Step 2. Decide how much you want to borrow: The next step is to decide how much you want to borrow against your home equity to finance your second home. It’s important to be realistic about how much you can afford to borrow and how much you’ll need to pay for a down payment on your second home. A tool like an affordability calculator may help you determine your budget.
Step 3. Consider your options: There are different ways to borrow against your home equity to finance a second home including traditional home equity loans, HELOCs, and cash out refinances. Comparing the pros and cons with each one may help you determine which type of financing offers you the terms and flexibility you need to borrow from your home equity.
Step 4. Apply for a home equity loan: Once you know how much you want to borrow, you can apply for a home equity loan to finance the purchase of your second home. You’ll need proof of income, credit score details, and other financial information to qualify. When you close the loan and the funds are available for you to use, you can put that money toward the purchase of a new home.
Step 5. Apply for a mortgage: If you need additional financing to buy another home, you will need to apply for a new purchase mortgage. Your personal financial information will be reviewed again by your mortgage lender, and you may use the funds from your home equity financing to cover costs including a down payment, closing costs, or other fees involved in the mortgage process.
Keep in mind that borrowing against your home equity can come with risks, such as the possibility of foreclosure if you’re unable to make your loan payments. Using your home equity to purchase another house is possible with careful planning and budgeting to make sure that you can afford to make regular required payments on all your loans.
Home equity loans can provide you with a large lump sum of money for a down payment on a second house.
Advantages of using equity to buy another house
Using home equity to buy a new home can be advantageous since home equity loans are secured loans and are available for lower interest rates and higher borrowing limits than many unsecured personal loans.
- Tapping into home equity helps capitalize on standing assets: By using home equity to buy a second home, you can pull from a stable source of money and possibly reduce the effects on your long-term finances. Withdrawing from certain other sources, such as long-term investments or a bank account, may possibly put a dent on your long-term financing plans.
- Home equity loan fixed rates can offer predictability: Home equity loans come with lower interest rates than personal loans because they are secured. Lenders see home equity as a high-quality form of collateral. Home equity loan interest rates are also fixed, so you can build a budget to make consistent monthly payments over a set amount of time. Use a monthly payment calculator to see how fixed monthly payments might work for you.
- A second home can diversify your assets: As opposed to taking cash from savings or an IRA, taking equity out of your home to buy another house builds on existing real estate assets. You may want to continue to diversify your portfolio as your assets appreciate in value.
- Potential for large down payment: Home equity loans can provide you with a large lump sum of money for a down payment on a second home. This large down payment may pay off in lower interest rates, lower monthly payments or reduced insurance premiums.
Disadvantages of using equity to buy a second home
While low fixed interest rates, high borrowing limits and steady payment schedules can make home equity loans appealing when buying another house, there are some risks with this strategy.
- If you are unable to repay loan, you risk losing both homes: If you use a home equity loan or do a cash out refinance of your original mortgage to purchase your second home, you are putting both your primary residence and second home at risk of foreclosure. When you default on a loan, the bank may have the ability to foreclose on your home to recoup the full value of the loan.
- HELOC variable rates may fluctuate your monthly payments: If you use a variable rate HELOC to finance your second home purchase, you will likely see the monthly payments for the HELOC move up or down over the life of the loan. Some HELOCs typically can use a variable rate (as compared to the fixed rate of a home equity loan), which is pegged to a national economic index such as the prime rate. While some HELOCs may permit converting to a fixed rate, you may have to pay additional fees for this service.
- Funds from home equity loan may not be tax deductible: Home equity loans and HELOCs may allow you to deduct the interest payments you make against the loan, but only when the funds from the loan go towards substantial home improvements. When you use a home equity product to finance payment towards a second home, your interest payments are not eligible for tax deduction. Make sure to consult a professional tax advisor to learn more about what your tax situation may be.
- You may owe more on your home than its market value: A second home also expands your pool of risk: if the value on either of your homes falls in a depressed market, you may find that the decreasing home value will have you owing more on your mortgage and home equity loans than the homes are worth at sale. If you are not planning on selling either home and can continue to afford monthly payments, this may not be a problem. But if you find yourself trying to sell either home, reduced market values may affect your ability to repay the loans.
- May prevent refinancing of first home’s mortgage loan: Having a second home loan on your primary residence may prevent you from refinancing your original mortgage loan. Some lenders may not allow refinancing until the second loan is completely repaid.
Alternatives to using equity to buy another home
Using a home equity loan for down payment on a new home may be considered the most obvious choice, but there are other ways to access funds you need to finance costs associated with the purchase of a second home:
- Retirement funds: Most retirement funds will charge you a penalty and fees for any early withdrawals you make against the fund, even when they go towards the purchase of real estate. However, if you can accept paying these charges, retirement funds allow an easy way to earn financing that won’t include checks against your credit or even equity in your current home.
- Personal loans: Like home equity loans, unsecured personal loans may allow you to find funding that you can put towards a second home. Compared with home equity loans, however, most personal loans will include higher interest rates and lower borrowing limits.
Closing thoughts: Using your home equity to buy a second home
Using your home equity to buy another house may be a way to achieve a brighter financial future if you can manage your debt and repay your loans on time. By following the steps outlined here, you may be able to achieve your homeownership goals and create an opportunity to build long-term wealth. However, make sure you consider your financial situation and ability to repay before borrowing against your home equity. By doing so, you may be able to minimize the risks associated with home equity loans and make the most of your finances as a homeowner.
Looking to tap into your home equity? Discover Home Loans is the #1 U.S. lender of home equity loans based on total dollar amount and number of loans for closed-end second mortgages, according to 2022 data available at the FFIEC Home Mortgage Disclosure Act website.
Please note: Discover offers home equity loans and mortgage refinance opportunities, but does not offer HELOCs or purchase mortgages.
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