Owning real estate is a solid stepping stone to the American dream. And once your family is settled, you may be looking at a second home purchase as an investment, rental property, vacation home-away-from-home, or part of your retirement plan.
If this sounds like you, you might find yourself wondering how to afford a second home. If you own a home with significant equity and have a solid financial plan, one way to meet this goal is a cash out refinance to buy second home.
But there are risks involved in using a refinance to fund that new property, and it’s not a funding method that’s ideal for everyone. In this guide, we’ll go over the benefits and downsides of refinancing so you can figure out if it’s the right solution or if a home equity loan alternative might be better.
What Is a Cash Out Refinance?
Before you start real estate shopping, it’s essential to understand the purpose and terms of a cash out refinance and learn how to identify it.
With a cash out refinance (sometimes referred to as ‘cash out refi’), you replace your original mortgage loan with a new, larger loan (hopefully with a lower interest rate). The extra money is given back to you in the form of cash that you can use on whatever you want. People often use a cash out refinance for home improvements, debt consolidation, or to buy a second home.
If you opt for a cash out refinance to purchase new home, keep in mind that:
- Your debt will grow – You’re increasing your current debt load by borrowing to cover the original mortgage debt you have plus the additional cash amount.
- The amount you can take out is based on equity – Your equity is the market value of your home today minus the amount you still owe on it. Most lenders will limit your cash out to no more than 80% of your home equity.
- There is no tax benefit – While you can deduct interest payments on your home, you can’t deduct the interest you pay on that cash back amount unless it’s used for substantial improvement to your home.
- There is no tax burden – The good news is that cash back is a loan, not income, so you won’t get hit with any federal income tax on this money. (Generally, this is true at all levels, but check with your mortgage lender or tax advisor to ensure there are no unusual local tax laws that may apply to you.)
How to Cash Out Refinance to Buy a Second Home
Wondering how to cash out refinance for a second home? By using cash out refinance to buy a second home or investment property, you’re borrowing against the equity in your main home to finance the downpayment and closing costs of a second home or investment property.
For example, if your current home has a market value of $350,000, and the amount you currently owe on your existing mortgage principal is $150,000, then your home equity is $200,000. This is regardless of what you originally paid for the house.
Lenders won’t let you borrow the full amount of your equity—most will cap it at 80%. So with $200,000 in equity, you could cash out up to $160,000. This means your total loan will be $310,000 ($150,000 to cover what you still owe on the house plus $160,000 in cash back to use for your second home).
That $160,000 in cash can be budgeted as you like. For instance, you could use it to cover the cash out refi closing costs, and the second home down payment and closing costs, and repairs and renovations to either property.
Is the Market Right for a Cash Out Refinance to Buy a Second Home?
Your home’s market value is based on what someone would pay for it today, and there are a few things going for you:
- Appreciation – With enough time, real estate almost always increases in value. If you were around in the 1990s, you may remember starter homes being widely available for under $100,000. Today, most of those homes are worth over a quarter million. Appreciation is what makes real estate a wise long-term investment.
- Seller’s market – When there are more prospective home buyers than homes available—which is currently the case in most of the United States—it’s a seller’s market. This means bidding wars and final sales over asking price are driving up the market values of similar homes in that area.
Your equity is likely higher than it’s ever been, giving you more opportunity to leverage your first home to buy a second home with a cash out refinance.
Quick tip: The home value you see on your annual property tax statement is its assessed value, which is almost always lower than its actual market value. A professional appraiser is best for an accurate valuation. You can check with a trusted real estate agent or a free valuation tool online.
Pros of Buying a Second Home With a Cash Out Refinance
Those who cash out refinance second homes get an advantage from opportunities and benefits, including:
- Making use of equity – Your home equity is a bit like an invisible savings account that’s growing while you’re not watching it. Many people never touch it until the sale of their home, when it turns into profit. But home equity is an asset that you’re building up as you pay off your first or current mortgage, and in some circumstances, it may be an asset to put to work for you.
- Renegotiating loan rate and monthly payment – A cash out refinance loan provides an opportunity to renegotiate your interest rate and loan term. If a lower monthly payment is a high priority, you may be able to achieve that with:
- A good credit rating
- Consistent payments on your current mortgage
- Lower average mortgage rates than when you took out your current mortgage
- Funding a hefty down payment – A second home mortgage down payment is usually at least 10%, a larger ask than for a primary residence. Ideally, you can make a down payment large enough to avoid private mortgage insurance, an added cost that can be avoided by paying down 20% of the sale price.
- Using the cash as they see fit – There are no limits on what you do with the cash you get back, so you can apply it as needed to cover things like furnishings for the second home, travel between the houses, or a second housewarming party.
Cons of Buying a Second Home With a Cash Out Refinance
There are also some cons to think through before deciding whether refinancing is the right choice for you. Consider:
- Loss of home equity – That cash out isn’t free. You’re losing the equity built up in your first home, which means less profit if you have to sell your home, or even owing on it if the market changes and it sells at a loss.
- Loss of rainy-day security – You won’t have the security of home equity as a borrowing source if you have unexpected financial costs like medical or family needs.
- Higher interest rates due to loan type – Cash out refinances typically result in paying more interest than you would with an interest-only mortgage, usually up to 0.25% higher than for a traditional type of mortgage refinance. They’re more complex than rate-and-term loans and may have higher underwriting standards.
- Higher interest rates due to your history – Unless you have an excellent credit score and a perfect payment history. you’ll be presented with a loan offer at a higher rate than current mortgage rates.
- Private mortgage insurance – If your level of home equity drops below 20% in your first home, you may be required to pay for private mortgage insurance (PMI), an extra cost of up to 2.25% of your loan amount per year.
- Risk of foreclosure – When you add to your debt with cash out on a refinance, you may be increasing your monthly mortgage payment, the length of your mortgage, or both. The more and the longer you owe on your house, the greater the chance that you could find yourself in an unexpected financial bind and risk losing your home by missing payments.
Should I Refinance My Home to Buy a Second Home?
Cash out refinancing can be a great way to make the downpayment on your second home, but it also has some risks and drawbacks. Deciding whether it’s right for you is dependent on your financial situation and goals as well as the real estate market. Consider:
- How long you plan to remain in your home – A general rule of thumb is 10 years. If you can count on staying in your current home that long, refinancing can be a good option. Consider both your current plan and the amount of risk you can predict based on job moves or family needs.
- Whether you should take on more debt – Do the math and figure out how the addition of debt from both cashing out your current home equity and taking on a second mortgage will hit your budget. With options to refinance a second mortgage, make sure your finances are in order. Unless you’re confident that there is no chance of missing payments and losing your property, proceed with caution.
Alternatives to Cash-Out Refinancing for a Second Home
There are a couple alternatives to cash-out refinancing for a second home that may be a better fit for you and your situation.
Home Equity Loan
The first alternative is a home equity loan. With this, your original mortgage loan is restructured, resulting in a new fixed monthly payment and interest rate for the term of the loan, like a personal loan would be. The difference between the original home loan and new home loan amount may be invested in other assets, such as stocks, or used as a down payment on a new home. If you get a denied home equity loan application, you may not have enough home equity.
Home Equity Line of Credit (HELOC)
Another alternative is a home equity line of credit, or HELOC. Opposed to home equity loans, HELOCs have little closing costs and a variable interest rate, and are similar to a credit card. You can withdraw money as needed and repay it for the first few years of the loan term. HELOCs are typically used to pay for home improvement projects and other needs that aren’t as pricey as buying a new house.
Is There a Better Way to Buy a Second Home?
If you’re feeling overwhelmed, you’re not alone. Though a cash out refinance for a down payment on a new home is one choice, there are other ways to move forward with a second home purchase that offer more flexibility.
A sale-leaseback solution may offer an alternative to refinancing and loans through financial institutions that limit their best rate offers to those with high incomes, low debt ratios, and pristine credit history. This program allows you to convert your home’s equity to cash when you sell your home. The best part? You get to stay in your home with a lease, while you look to buy a second.
There are risks involved in using refinancing to fund a second home. There are benefits and downsides of refinancing, and there are various other solutions such as a home equity loan. If you are still unsure of alternative options to securing this specific loan, after reading this article, consult a financial advisor to discuss your options.
This article is published for educational and informational purposes only. This content is based on research and/or other relevant articles and contains trusted sources, but does not express the concerns of EasyKnock. Our goal at EasyKnock is to provide readers with up-to-date and objective resources on real estate and mortgage-related topics. Our content is written by experienced contributors in the finance and real-estate space and all articles undergo an in-depth review process.
- NextAdvisor. Guide To The Tax Implications Of A Cash-Out Refinance. https://time.com/nextadvisor/mortgages/refinance/cash-out-refinance-tax-implications/
- NerdWallet. What to Know About Buying a Second Home. https://www.nerdwallet.com/article/mortgages/buying-second-home
- NerdWallet. Cash-Out Refinance Pros and Cons. https://www.nerdwallet.com/article/mortgages/refinance-cash-out
- CNN Underscored. Know the pros and cons before you take cash out of your home with a refinance. https://www.cnn.com/2020/11/23/cnn-underscored/cash-out-refinance-pros-and-cons/index.html
- Investopedia. Cash-Out Refinance. https://www.investopedia.com/terms/c/cashout_refinance.asp