Buying a second home can open up many possibilities for families, including access to new jobs, more comfortable vacations, and options for rental incomes, among others. While several means for buying a second home exist, such as obtaining a typical mortgage or selling off investments, another way to manage the purchase of a second home is to use the equity in your current home to pay for the second home or condo.
If you have enough equity in your home to buy a second home or vacation property, there are plenty of good reasons to pay with a home equity loan or home equity line of credit (HELOC). It has great advantages over taking money out of IRAs or 401(k) investments, which comes at a great cost in taxes and penalties. Plus, once that money is taken out of retirement investments, it can take a very long time to build that savings back up.
A home equity loan allows you to borrow the equity — the amount your home is worth, minus the amount you owe — through what is called a cash-out refinance. Basically, this means you take out a new loan on your home which includes the balance you owe, plus the amount of equity you want to borrow.
Lenders often look favorably upon buyers under these terms because the first home acts as collateral, and the buyer will only be making one payment per month. Statistically, buyers with two separate mortgages are more likely to default on the second loan if their financial circumstances take a plunge, but with a home equity loan on the primary residence, the buyer is less likely to default and risk losing one or both homes. Lenders may offer better rates and terms on a home equity loan rather than a second, separate mortgage for these reasons.
Using a home equity loan for the purchase also cuts out a lot of the fees associated with the new home purchase as required by banks. With the home equity loan, the lending bank has little input on how the money can be spent, so typical real estate transaction costs like title insurance and searches aren’t included in the cost of the loan. However, it is prudent to conduct a title search to ensure you won’t be stuck with any liens or end up in litigation over the sale.
Another advantage of having cash from a home equity loan is that you may be able to purchase properties in foreclosure, on short sales, or at auction which require full cash payment when the sale is accepted. This can create some flexibility and buying options that wouldn’t be available if purchasing with a traditional mortgage. The turn-around time from applying for the home equity loan to having access to the fund is often much shorter than the mortgage initiation process as well.
Like most things in life, using this method has its drawbacks as well as its advantages. First, your bank will own more of your first home, which means it will take years to rebuild any equity in the home and longer to pay it off. This means if a large expense is not covered by insurance, such as a new roof, the money may not be there to borrow.
A longer payout length means paying more interest over time, although possibly less than two concurrent mortgages. You’ll also be shoveling out significantly bigger mortgage payments every month for a long period of time. If your retirement plan relied on having your home paid off by the original mortgage end date, you will need to revisit your retirement plans and reevaluate your approach.
You’ll also have more money invested into one type of asset — real estate — for a very long time, and that is money that can’t be easily moved. If the real estate market, where either or both of the homes are located tanks, it will take even longer to build equity in the homes. However, there is no free ride when it comes to purchasing a second home, and using a home equity loan certainly has advantages over most other means.