A second property can be a great investment. Whether you buy a vacation home in an up-and-coming destination or an investment property that you rent out to full-time tenants, that real estate can start going to work for you as soon as you buy it.
Of course, most people don't have the kind of bank balances that let them buy a second house in cash. Then you start to think, “Can I use home equity to buy another house? How much do I need?” And then, “Do I even qualify?”
Home Equity Loan Eligibility
When you apply for a home equity loan, a lender will check on the value of your home, the amount of equity you have, and your ability to pay back what you borrow. The minimum requirements in most cases are as follows:
- A loan-to-value ratio of 80 percent or less. Even after you've borrowed equity through the new loan, you need to still own at least 20 percent of your home's market value.
- A sufficiently low debt-to-income ratio, which is the percentage of your take-home income that you use to pay down debt. Expect your lender's required maximum DTI to be 50 percent or less.
- A good credit score—ideally 700 or higher, but you might be able to get a loan with a slightly lower score if DTI and other factors are in your favor.
- Enough income to support your monthly payments without bringing your DTI above the maximum.
Assuming you meet these requirements and any others your lender sets, you'll get an estimate of how much you can borrow.
So that's the answer to “Can I use a home equity loan to buy another house?” You certainly can. But should you?
Using Home Equity to Buy Property – Pros and Cons
Like any financial decision, using home equity to buy more property has its risks and potential benefits. Each one will weigh differently for each person, so look at all of the factors before making a decision.
Pro #1: It's easier than applying for a mortgage.
Lenders almost always have stricter requirements when you take out a mortgage to buy a second house. You may have to:
- Submit a down payment of 10 percent to 30 percent
- Prove that you have enough cash available to cover a month to a year of payments
- Have a credit score of at least 640 to 700
- Show a debt-to-income (DTI) ratio of no more than 43 percent
Credit score and DTI requirements for a home equity loan are similar to those of a first mortgage, but cash payment requirements may be higher. That's because lenders consider second homes to have a higher risk of default than a borrower's primary residence.
With a home equity loan, your primary residence is your collateral. Lenders consider this arrangement to pose less of a risk, so your terms will probably be better. Also, a home equity loan doesn't carry closing costs, insurance requirements, and other expenses that go along with a mortgage.
Pro #2: Home equity loans let you borrow more and pay less in interest.
With a home equity loan, you can borrow up to 85 percent of the equity you've built up. In exchange, you'll pay an interest rate the average of which ranges from 5.09 for a five-year fixed-rate loan to 5.76 percent for a 15-year fixed-rate loan.
Interest on these loans has been rising over the past year as the Federal Reserve increases rates, but it's still below what you'd pay for a personal loan. Even with an excellent credit score of 720 or above, personal loan borrowers still pay at least 10.3 percent in interest.
The borrowing limit is usually not much higher than $100,000. With enough equity, you can borrow much more through a home equity loan.
Con #1: You could lose your home if you default.
A lender will put a lien on your home when you use it to take out a home equity loan. If you don't make payments on time, that lender could take your home to settle your debt.
The lien also gives the lender first priority for repayments, so you'll have a much harder time getting a loan until the lien is gone.
Con #2: Your home could lose value and be worth less than you owe.
When you liquidate your equity, you increase your loan-to-value ratio, which is defined as the percentage of your home's value that you still owe to a lender. If your home decreases in value before you're able to pay off enough of the loan, the value could be lower than the loan amount, putting you “underwater” on your mortgage.
An underwater mortgage makes it difficult for you to sell or refinance since your income wouldn't be enough to cover the debt. If you then have trouble making payments, you'd be at a high risk of foreclosure.
Alternatives to Home Equity Loans
A home equity loan isn't the only way to borrow against your equity. Here are two of the most common alternatives.
1. Home Equity Line of Credit (HELOC)
If a home equity loan isn't right for you, you could try a home equity line of credit, also called a HELOC. It's similar to a home equity loan in terms of qualifications, but a HELOC functions more like a credit card. You get approved for a maximum borrowing amount and can borrow up to that total as you need it.
Unlike a home equity loan, a HELOC has variable interest rates, which means that you could end up paying more if rates keep rising. However, upfront costs tend to be lower with a HELOC versus a home equity loan.
2. Cash-Out Refinance
As the term indicates, a cash-out refinance means that you're changing your mortgage to cash in on your equity. You simply take out a new mortgage for the amount you currently owe plus the cash value you want to extract. The new loan pays off the old one and then becomes your primary mortgage.
Some homeowners prefer this option because they only have to keep track of one loan instead of two. Also, the interest rate tends to be lower with a cash-out refinance than with a home equity loan.
That said, your rate with a cash-out refinance may still be higher than your current rate. Also, you'll still have to pay all of the closing costs associated with a new mortgage.
Don't Want a Loan? The Sell and Stay Alternative
If none of the above strategies suits your needs and budget, there is another option. It's called Sell and Stay by EasyKnock, and it allows you to sell your home but remain in place as a tenant.
You still get an agreed-upon percentage of your equity, while also freeing yourself from the burden of property taxes, repairs, and insurance. The difference is that you don't have to move!
Sell and Stay isn't a loan, so you won't take on any new debt. And because it's based on your equity, you don't have to submit a credit score, proof of income, or anything other personal financial info.
Want to learn more? Give EasyKnock a call today and find out how your current home can help you buy a second one, with no loans and no disruption to your life.