How to Use Your Home Equity To Buy Another House (Investment or Second Home)

Do you have plans or dreams to purchase another house — whether investment property or a second home — and looking for creative ways to finance the purchase? This is a very common question among homeowners, especially those with a lot of home equity built up in their primary residence, so today I want to share how homeowners can expand their wealth by using a home equity loan to buy another house. By leveraging your equity to expand your real estate holdings, you open yourself up to additional income streams and increased net worth.

There are some nuances to be aware of. Read on as we go through the pros, cons, and alternative funding options to consider.

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Know Your Investment Options

When it comes to buying another property, you have two investment options. A secondary home and an investment property. What is the difference?

Second home

A secondary home is your “home away from home.” Usually, a second home is in a vacation-type area; however, that is not required. Some homeowners have second homes for work; others have second homes to visit family members more frequently. Most mortgage lenders require the second home to be at least one hundred miles from your primary residence.

Investment property

An investment property is when your property is rented out to a long-term tenant or a short-term stay arrangement (such as Airbnb and Vrbo). Investment properties have more restrictive underwriting guidelines compared to secondary homes because investment properties have a higher default rate. With an investment property, the owner establishes a lease with a tenant or advertises the property as a short-term rental.

If you choose to pursue a rental property, you’ll want to add to your toolbox a service that can inform you about market rents in the area you are looking to buy. Having this information will be key to a successful purchase.

And suppose your rental property will be used as a short-term rental property. In that case, you’ll want to add a short-term property rental service that will evaluate the property you are considering, and it will show you if your property is a smart investment based on other short-term rental properties in the area.  

Differences In Underwriting Requirements

Second-home properties will come with less restrictive underwriting guidelines than rental properties. There are four main areas in which underwriting guidelines for investment properties are stricter than second-home properties.

• Credit score
• Loan-To-Value (LTV) ratio
• Debt-To-Income (DTI) ratio
• Liquid asset requirements

Underwriting requirements will differ from lender to lender; however, here are some general guidelines for a second home.

• 700 or higher credit score
• 90% or lower LTV ratio
• 45% or lower DTI ratio
• Three – Six months of liquid asset reserves

 Here are general guidelines to follow for an investment property.

• 720 or higher credit score
• 80% or lower LTV ratio
• 40% or lower DTI ratio
• Six months (or more) of liquid asset reserves

Again, these are general guidelines. The lender you work with might have more or less strict requirements.

Mortgage Rates Differ

Second-home properties have lower mortgage rates than rental properties. The difference will vary from lender to lender, but you’ll probably see a 0.25% to a 0.50% higher rate with a rental property (fees being equal).

Can You Use A Second Home As A Short-Term Rental? 

Great question, and the answer is that it might be possible. Buying a “second home” has to be the primary purpose; otherwise, your transaction with the lender is fraudulent. That means most of the time; you will be the user of the home.

But let’s say you periodically want to offer the property (or part of it) to a short-term renter through Airbnb or Vrbo. The lender might be ok with this, provided it’s limited. Discuss this with your loan officer to ensure you meet the lender’s requirements. 

What are the advantages of using a home equity loan to buy another house?

Using a home equity loan to purchase another property can give you more flexibility and options. Here are some of the things you might benefit from by tapping into your home equity.

You have more buying power with a larger down payment

By using a home equity loan, you can place a larger down payment on another property. This can allow you to buy more expensive real estate or get a smaller loan with lower monthly payments. It can also allow you to meet down payment requirements. Investment property loans, for instance, typically require a larger down payment compared to owner-occupied homes.

However, make sure to factor in the monthly payment on the home equity loan to ensure you can afford all of your housing expenses. 

You can buy a property that is otherwise not eligible for financing

If a lender won’t issue financing on a property because it does not meet its lending requirements, you can buy it free and clear with funds from a home equity loan. You’ll need a significant amount of equity to do so, but doing so can allow you to bypass a lender’s typical requirements for the property to be in a habitable condition.  

You can get another source of income

Using a home equity loan to acquire an investment property can allow you to get another stream of monthly income. Make sure that your expected return on investment outweighs the costs and potential risks. To do this, you’ll want to factor in all related expenses like your mortgage loan payments, repairs, and maintenance. It may also be a good idea to have conservative calculations for any projected rental income to account for periods of time in which the investment property may be unoccupied. 

What are the risks of using home equity loans to buy another house?

The primary risk with is losing both your primary residence and the other property if you can’t afford the payments because, with home equity loans, your house is used as collateral. Missing too many payments could result in the bank foreclosing on your home. Because of this possibility, taking out a home equity loan is not something that should be taken lightly.

If you’re using a home equity loan to purchase an investment property, it’s a good idea to consider whether you can afford both payments if you end up generating less income than expected.

Home equity loans can be more expensive than other types of financing

In addition to having to pay closing costs, home equity loans can have higher interest rates than conventional mortgage loans. Part of this is attributed to the fact that home equity loans are second mortgages and are higher risk for lenders since the loan is junior to your primary mortgage. In the event of a default, lenders will foreclose on a home to recoup some of its financial losses. Lenders holding a second mortgage to a property will only receive funds after the first mortgage holder and other state and federal debts have been satisfied. 

It can make refinancing your existing mortgage more difficult

Getting a second mortgage, such as a home equity loan, can make it more challenging to refinance the underlying first mortgage. Doing so would require the company holding the home equity loan to agree to the terms of the new first mortgage, a process referred to as a subordination agreement. Lenders will also factor in your payment on the home equity loan to determine if you can afford the payments on a new first mortgage for a refinance.

Evaluate Your Financials And Calculate Your Equity 

The next step in using your home equity for another property is to evaluate your current financials and determine the equity in your home. This is a broad-based assessment to determine your capacity to purchase another home and the amount of money you can work with before you make that offer.

Evaluate Your Financials

The most important thing to know about evaluating your financials is that you don’t want to overcomplicate the process. Here is a simple snapshot that is informative and quick. The amount you input for the first two categories is based on monthly amounts. The amount listed for the three categories is the total amount. 

Income

For monthly income use the amount listed in Box 1 on your W2 then divide by 12. If you are self-employed, use your net profit; if you are retired, use the amount of your retirement income deposited into your account each month (i.e., social security, pension, etc.).

Expenses

This will require a bit more work and might be the most important category. The total expense includes everything that comes out of your account each month, for example.

• All debt payments (house, car loan, credit cards, student loans, etc.)
• All monthly livings expenses
• Semi-annual property tax payments (break it down to a monthly amount)
• Annual property insurance amount (break it down to a monthly amount)

You should take the time to make sure this number is 100% accurate. Grab your most recent six or twelve months of bank statements to ensure you get everything.

Debt

The debt column is the total amount of all the debt you owe, including your house, car loan, credit cards, and even small amounts you may owe to friends or family members. As with the expense column, don’t leave anything out.

Investment Funds

Investment funds is the money you will use towards the purchase of another property. This is where your down payment and closing cost money will come from. Do not include funds you use to cover your usual monthly living expenses and your emergency reserve fund.

If you’re looking to improve your investment portfolio, be sure to read these four simple investment strategies before you invest that extra cash.

Liquid Assets

Liquid assets are cash reserves in case you have an emergency. If you need liquid assets to qualify, a retirement account like a 401k is usually acceptable. However, just because you can use it doesn’t mean it should be your emergency reserve account. The purpose of your 401k is for retirement, not for emergencies. I suggest establishing a specific cash reserve account for emergencies so that your retirement is protected.  

How To Calculate Home Equity

Here is the math equation for calculating your home equity. House value minus total loans attached to the property equals home equity. Here is an example.

• House value: $500,000 
• Total loans: $300,000

Equation: $500,000 – $300,000 = $200,000. So your total home equity is $200,000.

Loan Products To Access Your Home Equity

Now that you know your home equity, how do you access it to buy another property? Your three main loan options are obtaining a new first mortgage, a traditional fixed-rate second mortgage, or a Home Equity Line of Credit.

First Mortgage

A first mortgage is a loan attached to your property and is the primary loan most homeowners obtain when purchasing a property. Conventional, FHA, and VA home loans are the most common first mortgage loans.

Conventional home loans include Fannie Mae and Freddie Mac conforming loans and Jumbo mortgages. Federal Housing Administration (FHA) home loans are government-backed loans designed for first-time homebuyers and/or those with less-than-perfect credit. VA home loans are for those that have served in the armed forces.

Home Equity Loan 

A Home Equity Loan is a fixed-rate second mortgage that is a secondary loan to the first mortgage. It comes with a fixed rate and usually lasts ten to twenty years. Home Equity Loans come with a higher rate when compared to first mortgages, and your monthly payment is both principal and interest.

Home Equity Line of Credit

A Home Equity Line of Credit (HELOC) is a credit line secured by your home. Like a Home Equity Loan, a HELOC is usually in the second position after your first mortgage. Some homeowners chose not to have a first mortgage and then obtain a HELOC. In that case, the HELOC would be in the first position.

You can learn more about the difference between the two in our guide: HELOC vs Home Equity Loan. 

Which One Is Best For You?

Determining which loan option is best for you can be done by evaluating the pros and cons of each option and how that matches up with your current situation. Some homebuyers might prefer a new first mortgage. Others might want the stability of a fixed-rate mortgage but don’t want to touch their existing first mortgage, so they’ll opt for a fixed-rate second mortgage. A HELOC is an excellent option for those wanting flexibility and options to redraw the borrowed amount.

Educating yourself on the various ways to access home equity will enable you to be more successful with your purchase.

How Much Home Can You Afford

There are various ways you can determine how much you can afford. Here is a simple yet informative way of making this decision.

• If you are buying an investment property, prepare to have 25% down plus three to six months of cash reserves.
• If you are buying a second home, prepare to have 10% (or more) down plus three months of cash reserves.
• Regarding your total debt-to-income ratio (DTI), you’ll want to ensure you are at or below a 40% DTI.

Step-by-step explanation on how to use home equity for purchase of another property

Lenders that find out you plan on using the home equity loan to buy another property may want details on how you plan on using the other home, as well as what the costs will be. In rare circumstances, it’s possible that a lender with strict approval criteria could disqualify you from the loan if it determines you cannot afford the payment on both homes. 

Otherwise, the process of getting a home equity loan is the same, and we’ve outlined the steps below. 

Find a lender and submit a loan application

With home equity loans, it’s important to shop rates with multiple types of lenders such as credit unions, banks, and online lenders. Each has its pros and cons with regard to customer service hours, rates, fees, and types of loans offered. Shopping rates with multiple lenders will improve your chances of getting the best loan for your needs. 

• Banks: Banks can have a wide range of loan types, but eligibility criteria tend to be strict and it can be difficult to get policy exceptions if you don’t meet the qualification requirements. 
• Credit unions: Credit unions are not-for-profit organizations, so you can get more favorable rates and fees compared to banks. This type of lender also typically has a greater ability to issue policy exceptions if you have enough compensating factors in your loan application. 
• Online lenders: Online lenders have few, if any, physical branch locations. With fewer overhead expenses, it can offer some of the best loan rates and pricing for home equity loans. However, some online lenders may have shorter customer service hours compared to banks and credit unions, and their rates are not always the most competitive.

Provide the lender with required documents

Once you’ve submitted a loan application, you’ll typically need to provide the lender with supporting documents. This typically covers aspects of your credit, income, and assets. 

• Credit: Lenders will review your credit score and may ask for explanations for derogatory items on your credit report, or request loan statements detailing loan terms for your monthly debt obligations. 
• Income: Standard documents can include pay stubs, W2s, and personal tax returns. If you’re self-employed and running your own business, you may also need to provide business tax returns and other financial statements like a balance sheet or profit and loss statement. 
• Assets: If a lender requires reserves or proof of sufficient funds to cover closing costs, you may need to provide copies of a bank statement showing a large enough balance. 
• Additional property information: This can include things like your homeowner’s insurance or homeowner’s association bill. 

Lender orders appraisal and other third-party items

In addition to reviewing your own documents, lenders will also order a number of third-party services to verify other aspects of your property. This can include things like your home’s value, its condition, the legal owner of public record, and more. Below are some examples of items a lender might request from a third-party vendor:

• Appraisal: An appraisal will be required for most home equity loans, and is used to determine your property’s value and how much equity you have in the home. It can also be used to evaluate the condition of the property. Appraisals can be done with a computerized model, or require a physical inspection by a certified appraiser. 
• Title report: A title report is completed by a title company to verify the legal owner. It will also reveal the property’s liens, including outstanding mortgages and unpaid tax liens. 
• Tax certification: A tax certification can be conducted to verify the amount of property taxes due and whether your account is delinquent. 
• Flood certification: Properties located in a flood zone will require additional flood insurance before most lenders will issue financing. 

Loan approval is issued

Once a lender has obtained and reviewed the documentation above, it will issue a decision on the loan. There are typically five possible outcomes:

1. Approval: The best outcome is that your loan is approved at the terms you have requested, with no additional documentation being required. 
2. Conditional approval: With conditional approval, lenders usually just need a few minor pieces of additional information. In most cases, it’s a good sign that you’ll get the loan terms you initially requested. 
3. Counter-offer: This can occur if the lender can issue financing, but just not at the terms you requested. They may issue a lower loan amount, a higher interest rate, or require you to pay off debt. 
4. Suspend: A loan can be suspended if a lender is missing critical pieces of information where there are multiple paths forward. If this occurs, lenders will ask you for clarification or additional information to determine what documentation it may require. 
5. Denial: A loan can be denied if a lender is not able to issue any type of financing. If this occurs, you’ll have a chance to discuss the decision with a loan specialist to determine how you might become eligible in the future. 

Docs are signed

If your loan is approved, the next step is to sign the final loan documents with a notary. The purpose of meeting with a notary is to verify your identity. Lenders will schedule this for you, and you should expect a phone call from the notary to confirm the details of the appointment. Requirements can vary among different states, but most notaries will require one or two copies of a government-issued photo identification, such as a driver’s license or passport. 

Home equity loan funds

Once you have signed the loan documents, they will be returned to the lender for review. This is done to ensure everything was signed properly. Once you get to this stage, it can take between one and three days for your loan to be funded. Funds can be disbursed to you as a lump-sum payment to your bank account.

What are some alternatives to a home equity loan for the purchase of another house?

If you’re not sure if a home equity loan is the best option to acquire another property, here are some alternatives to consider:

• Cash-out refinance: With a cash-out refinance, you’ll be replacing the terms of your existing mortgage loan. Your new loan will have a larger balance, some of which will be used to pay off the old loan. You can then use the remaining funds toward the purchase of another property.
• Retirement accounts: Some retirement accounts, particularly employer-sponsored accounts like a 401(k), allow you to withdraw funds for the purposes of purchasing real estate. Each plan is different, so you’ll need to review the terms of your plan to determine the specific eligibility criteria. For example, you may only be allowed to withdraw funds for the purchase of an owner-occupied property, but not an investment property.
• Investment accounts: If you don’t have a sufficient amount of funds in a checking or savings account, you can consider liquidating all or a portion of your investments. Investment accounts can include individual stocks, bonds, or mutual funds. 
• Gift from family members: Many lenders allow for gift funds to be used as long as the home being purchased is not an investment property. In other words, it’s often allowed for a vacation home or a primary residence. Gifts must typically be from a family member, relative, or individual who has a familial relationship with you. This can include parents, a domestic partner, a godparent, or an individual engaged to marry one of the borrowers. 

Personal loans: A personal loan typically cannot be used towards the purchase of another home. However, guidelines vary from lender to lender. If you have exhausted all other options for funding, it’s worth asking a lender if it will allow the use of personal loans.

Should I use a home equity loan to buy another house?

Using a home equity loan to purchase another home can have a number of benefits. You can get more funding for a larger down payment, acquire a property that otherwise would not qualify for financing, and more. However, it also carries some risks such as potentially losing your home if you can’t afford the added monthly payments.

Before you make any final decisions, it’s important that you explore alternative financing options and understand the costs and risks involved with using a loan to buy another property.

Disclaimer: The above is provided for informational purposes only and should not be considered tax, savings, financial, or legal advice. All information shown here is for illustrative purpose only and the author is not making a recommendation of any particular product over another. All views and opinions expressed in this post belong to the author.