Monday, January 24, 2022

Can I Use a Home Equity Loan to Buy Another House?



 


Can I Use a Home Equity Loan to Buy Another House?

If you have a significant amount of equity in your primary residence, you can tap into it through a home equity loan. You can then use that money for any purpose that you wish, including buying a second home or an investment property. Using a home equity loan to buy another house is not without risks, however, so it’s smart to understand the pros and cons before you proceed.

KEY TAKEAWAYS

  • If you have enough equity in your home, you can use the money from a home equity loan to buy another house.
  • Like regular mortgages, home equity loans are secured by your home, so you will be putting it at risk if you’re unable to repay the loan.
  • There are alternative ways to borrow that may be better in some instances.

Using a Home Equity Loan to Buy Another House

The short answer to the question of whether you can use a home equity loan to buy another house is yes, you generally can. Bear in mind, however, that some lenders may have restrictions on the source of your down payment and may not be willing to issue a mortgage on the new home if you’re using a home equity loan for that purpose. Of course, that will not be a problem if you are paying all cash for the new home.

Unlike a home equity line of credit (HELOC), which provides a revolving line of credit, a home equity loan gives you the entire loan amount upfront. The amount will depend on how much equity you have in your home, its market value, and how much you want to borrow. Your income and credit history will also affect the loan amount. Most lenders will cap the total amount at a percentage (usually 85%) of the home’s value. When your home equity loan closes, you’ll receive the full proceeds and can then spend the money to buy another house or do whatever you want with it.

Pros and Cons of Using a Home Equity Loan to Buy Another House

The major advantage of using a home equity loan to buy a second home is that it may be your best (or only) significant source of funding if you find yourself house-rich but cash-poor. Another potential plus is that interest rates on home equity loans will often be lower than other forms of borrowing, though they are typically higher than interest rates on a mortgage.

The biggest downside of using a home equity loan for buying another property—or for any other purpose—is that you are puttig your primary residence at risk because it serves as collateral to secure the loan. If you find yourself unable to make the payments on your home equity loan, the lender could foreclose on your home and evict you.

An additional danger is that by taking on a home equity loan, especially if you still owe money on your first mortgage, you could find yourself overwhelmed by debt if you face an unexpected financial reversal, such as a job loss or big medical bills. Indeed, you could wind up obligated to pay off three mortgages at once: the remainder of the mortgage on your primary residence, a mortgage on your second house (if your loan isn’t large enough to buy the house outright), and your home equity loan.

Finally, another downside is that you’ll have to pay closing costs on the home equity loan, which could be between 2% and 5% of the total loan cost.

 You’ll also have to pay closing costs on the home that you’re buying.

Alternatives to Using a Home Equity Loan to Buy Another House

Before you apply for a home equity loan to buy another house, it’s worth considering the alternatives. They, too, have advantages and disadvantages.

Cash

The best source of cash to buy another house would be money that you have already saved and for which you have no other immediate need. Of course, if you have that, you shouldn’t be seeking a loan at all.

Retirement savings

Your retirement savings are a possibility. If you have a 401(k) plan at work, for example, your employer may allow you to borrow a portion of it through a 401(k) loan. Like home equity loans, retirement plan loans can be risky. You’ll typically need to pay back the loan within five years—even sooner if you lose your job. If you can’t pay it back, then you’ll owe income taxes and possible penalties.

 

If you borrow from your 401(k), you will have that much less money saved for your retirement years, which could mean financial problems down the road.

Personal loan

You could consider a personal loan. You’ll pay a higher interest rate than with a home equity loan or HELOC, but if the personal loan is unsecured, then your home won’t be at risk if you fall behind on payments.

Cash-out refinance

A cash-out refinance pays off your current mortgage with a larger one based on the accumulated equity in your home. You can then use the extra cash for other purposes. Of course, you’ll now have more debt and higher monthly mortgage payments. These loans also have closing costs that can run into the thousands of dollars.

Home equity line of credit (HELOC)

Using a HELOC to buy an investment property, rental property, or second home can give you more flexibility than you get with a home equity loan, in that you don’t have to take the money all at once. This might be useful if you need some cash now for a down payment and expect to need more in a year or two to make some renovations. However, HELOCs typically carry variable interest rates, making them less predictable than a home equity loan, which usually has a fixed rate.

Reverse mortgage

There probably aren’t too many people who are 62 or older and looking to become landlords in their retirement, but theoretically, if you meet that age requirement, you could take out a federally insured home equity conversion mortgage (HECM), better known as a reverse mortgage, to buy a rental property to provide you with an income stream in your twilight years.

A HECM converts the equity in your home into cash that is usually tax-free and doesn’t affect your Social Security and Medicare. The lender pays you the money, and you don’t have any monthly payments on the mortgage. Indeed, as long as you live in the home, you don’t have to pay the mortgage off at all, though you still must pay the costs of maintaining your home. However, when you move out of the home, sell the home, or die, you, your spouse, or your estate must pay the mortgage off in full, plus interest from a variable rate that accrues over the life of the loan and eats up the home’s equity.7

This means that if you plan on leaving your home to your heirs, there would be a hefty bill for being able to do so. Still, at that point, the proceeds from the sale of your rental property could possibly pay off the reverse mortgage.

CAN YOU USE A HOME EQUITY LOAN TO MAKE A DOWN PAYMENT ON A HOME?

Yes, if you have enough equity in your current home, you can use the money from a home equity loan to make a down payment on another home—or even buy another home outright without a mortgage. Note that not all lenders allow this, so if you’re planning to buy the second home with a mortgage, you may need to shop around to find one that does.

HOW MUCH MONEY CAN YOU GET FROM A HOME EQUITY LOAN?

Typically, you can borrow as much as 85% of your home equity. However, you may have to pay several thousand dollars in closing costs, so you won’t walk away from the deal with the full 85%.

WHAT ARE THE RISKS OF USING A HOME EQUITY LOAN TO BUY ANOTHER HOUSE?

The major risk of a home equity loan, as with a regular mortgage, is that it is secured by your home. This means that if you are unable to keep up with the payments, your lender could seize the home, sell it, and evict you. Instead of a home equity loan, you also may be eligible for an unsecured personal loan, which won’t put your house at risk, although it will typically have a higher interest rate.

WHICH IS BETTER: A HOME EQUITY LOAN OR A HOME EQUITY LINE OF CREDIT (HELOC)?

That depends on why you need the money. A home equity loan may be better if you need a lump sum of money at a particular time—such as to purchase another home. A home equity line of credit (HELOC) could be better if you don’t need the money all at once but expect to spend it in stages. Some lines of credit remain open for as long as 10 years.

From an interest-rate perspective, a home equity loan may be safer because its interest rate is fixed, while the rate on a HELOC is variable. Borrowers with HELOCs have some protection in the form of caps on how quickly their interest rates can rise, although that can vary from lender to lender.