Can you use the equity in your home to buy a vacation home? | Find the best loan for you
Buying a vacation home might make sense if you have a favorite vacation spot that you visit frequently. However, the financial consideration of a vacation home purchase is not the same as booking a hotel room one trip at a time. This is a long term expense that you will need to figure out how to pay for it.
If you’ve built up equity in your primary home, you could use it to buy a vacation home. This might minimize what you are spending out of pocket to buy a vacation home, but consider whether using the home equity to buy another property makes financial sense.
How Using Equity to Buy a Vacation Home Works
There are two ways to think about using home equity to buy a vacation home. The first is how to access your capital; the second is what it can be used for.
There are three main ways to take equity out of a home:
- Home equity line of credit
- Home equity loan
- Cash-out refinancing
All three can free up money that you can use however you see fit to buy a vacation home, says Carrington Carter, co-founder and chairman of real estate investment firm McKinley Carter Enterprises. But each can have a different impact on your financial situation.
A home equity line of credit, for example, is a flexible line of credit that you can draw on as needed. An advantage of using a HELOC To buy a vacation home, you may only have to make interest-only payments or you may have a low monthly payment for the initial drawdown period. But, Carter points out, HELOCs generally have a variable rather than a fixed interest rate. If interest rates rise, it could increase the amount of interest you will pay. And after the withdrawal period, you should expect to make full payment of principal and interest.
With a home equity loan, you get a lump sum that you can apply to your vacation home fund, and you’re more likely to get a fixed interest rate. Similar to a HELOC, you would have your regular mortgage payment to make each month, along with a payment for your home equity loan. This might require a budget adjustment to take into account the two payments.
Cash-out refinancing works differently. With this type of arrangement, you get a brand new mortgage to pay off the old one and withdraw your accumulated equity in cash. You only have one payment to handle in the future. That’s a plus, but if you extend the term of your new mortgage beyond the number of years you had left on your original mortgage, it could mean more interest paid over time.
When it comes to how equity can be used to purchase a vacation home, homeowners have some leeway.
“The beauty of your home equity is that it’s your money and it can be used however you want,” says Jeremy Sopko, CEO and co-founder of the direct mortgage company Nations Lending. “A vacation home will typically require 10-20% for the down payment, so depending on how much equity you have, you can either buy a home directly or use the equity in your primary home as a down payment. “
If you have a large amount of equity – that is, enough to buy a vacation home or make a large down payment with the remaining money – you can also use some of it to make renovations or remodel. your new getaway once the purchase is complete.
Should you use the equity in your home to buy another property?
The answer to this question depends on several factors, including the terms of your current mortgage and the method you plan to use to leverage equity. Sopko uses cash-out refinancing as an example.
“If your current mortgage is on favorable terms, you may not want to refinance that loan at all,” Sopko explains. “However, if the current market rate is lower than your primary mortgage, it is possible to refinance your first mortgage, get the cash, and have no additional costs associated with operating that equity. . “
The amount of equity you have is also important, as it can determine what type of equity financing option you are eligible for, if any.
Ann Thompson, Director of Retail Sales-West, Consumer Loans, Bank of America, says, “If you take out a HELOC, for example, the amount of available equity in your home plays an important role. Your equity helps your lender determine your loan-to-value ratio, which is one of the factors your lender will consider when deciding whether or not to approve your application. “
To determine your LTV, divide your current mortgage balance by the appraised value of your home. If you owe $ 100,000 on your mortgage and your home is valued at $ 300,000, your LTV would be 0.33 or 33%. Depending on whether you use a home equity loan, HELOC, or cash refinance to access your equity, lenders may require an LTV of 85% or less. In other words, you must have at least 15% equity in the house.
Thompson says owning a second home can bring potential tax benefits, depending on the type of property purchased and how it is used. But, she notes, owning a second home just for the holidays is different from owning investment property. “This difference can affect a buyer’s finances, including taxes owed on the property and the type of insurance coverage needed,” she says.
Alternatives to using home equity to buy a vacation home
There are other options for buying a vacation home that can leave your equity untouched.
For example, you could make the purchase or down payment in cash if you have the assets to do so. However, if you were to withdraw money from liquid savings, such as a savings account or money market account, you would like to be sure that you have enough cash to cover emergency expenses or repair costs.
Or if you use the assets of a tax-efficient retirement plan to buy the house or make a down payment, penalties could be imposed. If you withdraw money from a traditional or 401 (k) individual retirement account before the age of 59.5, you may have to pay a 10% early withdrawal penalty, as well as tax. on ordinary income on withdrawal. Not only that, but you would reduce your retirement nest egg.
What to consider before leveraging your capital
Carter says that if you plan to use your home equity to buy a vacation home, think carefully about the following:
- How much equity you’ll need to buy the house and how much equity you’re willing to use.
- How much rental income the house could generate.
- When a home equity refinance payment HELOC or potentially larger fits into your budget.
- What other qualifications you will need to meet to access your capital.
For example, lenders will also take your credit rating into account when you apply for a home equity loan, HELOC, or cash refinance. A credit score of 700 or higher should be enough to qualify for any of these options, but if your score is lower, say around 620 or lower, you may find it more difficult to get approved.
Keep in mind that your credit score also influences your interest rate. The higher your score, the better your rate and vice versa.
In addition to credit scores and LTV, lenders also consider your debt-to-income ratio. Carter says lenders generally set the range of acceptable DTI ratios at 43% to 50% for home equity borrowers.
You should also think about the impact that owning a second home can have on your finances in general. Not only might you have to manage two mortgage payments, but you’ll also need to factor in things like property taxes, home insurance, and vacation property maintenance. When in doubt, discuss options with your lender so you can decide whether buying a second home using your equity is the right decision.
“Making the equity in your home at the service of your family is one of the real benefits of homeownership; however, there is no general rule of thumb on how it should be used, ”says Sopko. “With the many loan programs, types of loans, and the large amount of guidelines present in loans, a consumer looking to purchase a vacation home should always contact a trusted mortgage expert first. “