The average mortgage holder now has a record $299K in equity, up from $274K in 2022. Homeowners are naturally considering real estate as the ideal investment in the current market. But this rise poses an important question: Can you use a home equity loan to buy another house?
The answer is straightforward; yes, you can. But many struggle with liquidity concerns even in a bull market, which makes it difficult to buy property outright. One of the best ways to secure additional funds in such cases is to get a home equity loan on an existing property.
You could also consider a home equity line of credit (HELOC), but both have its benefits and downsides. Once you decide to borrow against your home equity, you’ll need a lender that offers suitable terms.
What Is a Home Equity Loan?
A home equity loan is a second mortgage in which you borrow funds against your current property’s equity. Your existing home acts as collateral for the loan. You’ll receive a lump sum of cash that you must repay over a fixed term.
As you pay off the mortgage payments, your ownership of the first property will increase. The loan is based on the difference between your home’s current market value and the outstanding mortgage balance to find out existing home equity.
Lenders calculate the loan amount by assessing the current market value of your home and subtracting the amount you still owe on your mortgage. Your home equity is the residual amount, which you may borrow against with a home equity loan.
Fixed interest rates are a common feature of a home equity investment. In contrast, alternatives like home equity lines of credit for investment property have adjustable rates.
Are You Eligible for a Home Equity Loan?
Before we move on to the steps on how to buy another house while owning a house, let’s take a quick look at the eligibility criteria.
While the requirements might vary for different lenders, the criteria that most borrowers need to fulfill are:
- Have at least 20% of your home equity.
- Proof of earning money consistently for at least two years, such as tax returns and Form W-2.
- A minimum credit score of 620 credit score.
- Debt-to-income ratio of maximum 43%.
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Can You Buy Another House Using Home Equity?
Yes, you can buy another house with your existing home’s equity. There are two types of loans that let you purchase property using home equity:
1. Home Equity Loans (HEL)
A home equity loan offers a lump sum of money based on your equity in the existing home. Let’s assume the value of your home is $600,000, and you have a mortgage of $300,000. This means you have $300,000 in equity.
Now, assume the lender allows you to borrow up to 90% of your available home equity to buy another house. This means the maximum cash you can borrow is $600,000 × 0.90 = $540,000.
2. Home Equity Line of Credit (HELOC)
HELOC for investment property provides you with funds as and when you require it, depending on your equity. It acts like a credit card with a variable interest rate. During the first draw term, which is generally 10 years, you can withdraw money by debit card, check, or online. As you repay the loan, the credit limit increases.
However, once the initial draw period is over, you have to repay the principal and outstanding interest. This requires you to repay the principal amount you’ve borrowed, alongside accrued interest. It’s important to have a financial strategy to handle this shift without going over your budget.
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How to Use a Home Equity Loan for a Second Home?
The steps to purchase a second home against your current home’s equity are outlined below:
1. Set a Budget
When considering a home equity loan, start with a clear budget to plan your mortgage payments as well as your new home. Here’s what you need to assess:
- Expected earnings during the loan repayment period
- Costs throughout the loan’s duration
- Any existing debts
2. Calculate Your Home Equity
Next, calculate how much you can borrow using the loan-to-value (LTV) ratio. Divide your mortgage balance by your home’s value.
Considering the earlier home equity example, the LTV ratio would be $300,000 / $600,000 = 0.50 or 50%. Understanding the LTV helps both the lender and borrower estimate the feasibility and risk associated with the home equity loan.
3. Find a Lender and Apply
Once you’ve found a suitable lender, it is time to apply for a home equity loan. You’ll need to complete the loan application and provide details about your finances and home.
Respond quickly if the lender needs any additional documents or information from you. It increases your chances of getting approved for the loan amount you need at a good interest rate.
Home Equity Loan or HELOC?
Once your home equity loan or line of credit is approved, getting the loan amount takes anywhere from 2 weeks to a couple of months. Here is how you can use the money from a home equity loan or HELOC:
- Home Equity Loan: Having enough home equity will provide you with a lump sum payment to buy another property after you complete the application process. You can then use the funds from the home equity loan for a down payment on the next house.
- HELOC: A credit line works a bit differently. You’ll have a revolving credit line available to tap into and withdraw from as needed over time. Your HELOC lender will likely provide special checks or a debit card linked to your credit line.
No matter which option you choose, expect some downtime before getting full access to the funds from home equity loans or HELOCs.
Benefits of Using Home Equity to Buy Another Home
- Protect Your Assets: By taking out a loan against the equity in your current home, you keep your existing bank accounts and assets untouched.
- Instant Cash: Sellers and lenders tend to favor buyers who can make a sizable down payment or pay lump sum cash.
- Low Interest Rates: Home equity loans use your property as collateral. Lenders typically charge lower interest rates compared to other unsecured debts.
- Long Tenure: Home equity loans usually last 30 years so the monthly payments are smaller in comparison to other loans.
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Risks of Using Home Equity to Buy a Second House
- Risk of Losing Your House: Your current house is the collateral for the equity loan. You may lose the house if you don’t make mortgage payments on time.
- Low Return on Investment: Home values could drop after the loan. If so, you may owe more than your house is worth.
- Additional Closing Costs: Calculate closing costs. These include an origination fee of 0.5% to 1% of the amount and an appraisal fee of $400-$700.
- Higher Interest Rates: Equity loan rates are higher than original mortgage rates. So, the new debt may cost more in interest over time.
Alternatives to Fund Your Next Home Purchase
Home equity loans and HELOCs are simple options to buy a second home. However, financing options are not limited. Some alternatives to buy a second house are:
- New Mortgage: Get a regular mortgage on the new property under conventional loans, like FHA loans, or VA loans. It prevents the risk of losing your existing home and the mortgage interest may be tax deductible.
- Retirement Savings: Use funds from your retirement accounts like a 401(k) loan if your plan allows it. However, you will need to repay it within 5 years.
- Personal Loans: Apply for a personal loan from a bank. Although they have higher interest rates, your existing home remains safe.
- Reverse Mortgage: If you are over 62 years, look into a reverse mortgage. It provides cash from your equity over time.
- Alternate Lending Options: Explore alternative lending options such as peer-to-peer loans or equity investment deals for homeowners.
Bottom Line
Buying a second home is a significant financial decision that requires careful planning. A home equity investment loan can provide the necessary funds to buy your next house. However, weighing potential risks is crucial to confirm you can comfortably manage the increased debt load.
The key to buying a second home through a home equity investment lies in finding lenders that offer terms suited to your needs. Once you ensure you meet all qualifying criteria, browse our list below of mortgage lenders near you to find the perfect match.
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Frequently Asked Questions
How much equity can I borrow from my home?
Typically, lenders allow homeowners to borrow up to 80% of their home's appraised value minus the outstanding mortgage balance.
Is it hard to get home equity loan?
Getting a home equity loan can be relatively easy if you have sufficient equity in your home and meet the lender's requirements. Generally, lenders will require a minimum credit score of 620 or higher, a debt-to-income ratio of 43% or less, and a maximum loan-to-value ratio of 80%.
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