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.
Below are the four steps to utilizing your equity to purchase additional property.
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?
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.
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.
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||Expenses||Debt||Investment Funds||Liquid Assets|
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.).
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.
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 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 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.
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.
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.
Establish A Relationship With Trusted Advisors
Most homeowners in the early stages of learning how to use their equity to purchase another home are not well-connected to realtors, mortgage loan officers, or contractors. How to get started might seem a bit overwhelming, but here is a straightforward path to follow.
- Find your agent and loan officer: use Google, Zillow, and Redfin
- Verify their quality and reviews: use Better Business Bureau, NMLS, and Yelp
- Find a contractor (if you need renovations): Angie’s List, Yelp, NMLS, HomeAdvisor, Thumbtack
When finding a realtor and a loan officer, I suggest starting with Zillow and following that up with the Better Business Bureau. When you visit Zillow, you can read their reviews (which Zillow verifies), and when it comes to the realtor, you can see the transactions they’ve worked on.
And you don’t want to just go with the person that has the most five-star reviews. You also want to review their bio and their closed transactions. Why? Because if you are someone looking to purchase a multi-family property, you will want a realtor that has lots of experience in that area. And you want to review the locations of their transactions so that you’re working with a realtor who truly knows the area you are looking to buy.
Then go to the Better Business Bureau website and review the Better Business Bureau grade. I suggest only working with companies with an “A-” or higher. And when it comes to choosing the person you want to work with, find out if you will be working directly with them or if someone on their “team” will be handling your search.
I would avoid working with a realtor who will assign me to someone on their team. I’m hiring an “expert,” not the assistant to the expert.
Regarding the loan officer, you can also use Zillow to find some options to consider and then go to the Better Business Bureau website. Again, I suggest only working with companies with an “A-” rating or higher. Second, your loan officer should have at least five plus years of experience as a loan officer to ensure you’re working with a knowledgeable person.
The final step in locating a loan officer to work with is going to the NMLS website to verify who this person is and review their work history. Regarding work history, it’s not uncommon for loan officers to move around within the industry, from one company to the next. However, if it’s excessive, that’s a red flag.
Like working with a realtor, I would never work with a loan officer who will pass me off to someone on their “team.” Working directly with the loan officer, who is the expert, is key.
Angie’s list is a great way to find local contractors. So once you have your realtor and loan officer, find yourself a trustworthy contractor. Ensure they are licensed and bonded and use the Better Business Bureau as an alternative source to verify the quality of their work.
Leverage Your Equity And Execute Your Strategy
You have your financials down, you’re clear on your available equity, and you have a rock-solid team; now what?
Before you start your search for another property, have a plan in place to leverage your equity. Your loan officer should pre-qualify you for the purchase and the loan you’ll need to access your equity. The pre-qualification for the purchase loan is different from the loan you’ll need to access your equity. The purchase loan requires verification of your liquid asset reserves, especially if you are buying an investment property, and in some cases the loan to access your equity will not need a verification of asset reserves.
To do this, your loan officer will provide a list of documents they need to approve you for both loans. Make sure you send in complete documentation in a timely manner. If you’re self-employed and the loan officer asks for your W-2s and paystubs, don’t send in your tax returns thinking that’s enough. Send in exactly what the loan officer is asking for, and if you can’t locate the document, ask the loan officer how you should proceed.
Once you’re pre-qualified for the purchase loan and the loan to access your equity, it’s time to work with your realtor. Set up a criteria list of what you are looking for and your price range. Here are some sample questions that you should answer to help your realtor find your ideal property.
- What is your price range?
- What type of property do you want to buy?
- If it’s a Multi-Unit property, do you want a duplex, a triplex, or a quadplex?
- If it’s a Multi-Unit property, how many bedrooms and bathrooms does each unit need?
- If it’s a Single Family Residence or a Condominium, how many bedrooms and bathrooms should the home have?
- What condition should the property be in?
- What repairs do you want to avoid? For example, if the property has mold and you don’t want to deal with mold, then let your realtor know that upfront.
- What part of the city/town should the property be in?
- Does the property need to be near public transportation, schools, etc.?
This is a partial list of the questions you should answer. The more details you can provide your realtor, the better.
Once that is done, your realtor can go out and find properties that match your criteria. Working with your realtor, you can analyze any investment property they suggest to see if it meets your financial goals.
During this time, keep in contact with your contractor. Send them links to properties you are considering, and ask them questions. Even if the property doesn’t need any work, get their opinion on the property you are considering if they’re familiar with the area.
Increase Your Wealth Through Real Estate
Building an additional source of income and increasing your wealth is achievable if you plan accordingly. Knowing your financials and working with House Numbers to determine your equity is key to getting started. Building an experienced and knowledgeable team of industry pros will open the doors to different opportunities and improve your bottom line. Working on your personalized strategy to execute your first purchase will improve your chances and help you reach your goal of long-term wealth.