Buying a Second Home: Best Ways to Finance Your Purchase

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The requirements for financing a second home purchase are stricter than for primary residences. There are also additional expenses and tax implications that apply specifically to second homes and vacation properties that are different from those for primary homes and investment properties.

Best Ways to Finance a Second Home

Based on our research, the best way to finance your second home is through the use of home equity from your primary residence. Not only is home equity the largest available asset for most families, it's also high-quality collateral that lets borrowers access better interest rates in the form of home equity loans, reverse mortgages (if you're in you're 60s), or cash-out refinancing. Loan assumptions and 401(k) financing are also valid options, but each comes with its own drawbacks.

Home Equity Financing

Home equity products are one of the most popular ways to finance a second home because they allow access to large amounts of cash at relatively low interest rates. The qualification process is easier than a standard mortgage loan and the lender usually doesn't care how the proceeds are used after they're disbursed. Home equity proceeds are also treated like cash during a home purchase, which can be advantageous if you're trying to close quickly. Home equity financing typically comes in two forms:

Home Equity Loans

Home equity loans allow you to borrow money against the equity you've built up in your home. These are installment loans that consist of a lump-sum payout, repaid in equal monthly payments over time, similar to the mortgage on your primary home. These offer a fixed rate of interest that does not change for the life of the loan. These make it easy to access a large amount of cash for a new home purchase that you can pay down in manageable installments over time.

Home Equity Line of Credit (HELOC)

Alternatively, HELOCs are revolving lines of credit that can be drawn and repaid, similar to a credit card; this makes them an excellent flexible spending option for down payments. However, it's generally not advisable to draw on the entire line, as this increases your credit utilization ratio and negatively impacts your credit score.

Additionally, the variable interest rate on these loans subjects you to greater volatility on your monthly payments. As such, home equity loans may be a better option if the down payment on your second home exceeds 30% of the available credit line on your HELOC.

Regardless of which type of home equity financing you employ, your new debt will place your primary residence at risk if you end up defaulting on the loan, which puts you in a position of double jeopardy of losing both your primary and second homes.

When considering home equity financing, make sure you're able to meet the monthly payment requirements on your home equity loan combined with any other installment debts you have outstanding. The last thing you want to do is run the risk of losing your primary home because you weren't able to make the combined payments on your two properties.

Tax Issues of Purchasing a Second Home Using Home Equity

Under the 2018 tax law, the mortgage interest on home equity financing is no longer tax-deductible unless the proceeds are used to improve the home that it secures. That means that if you take out a home equity loan or HELOC against your primary home and apply it toward the purchase of a vacation home, the IRS will not permit you to write off the interest on that home equity debt.

Interest on home equity products is only tax-deductible if it's used to finance substantial improvements to the property that it secures. This works for both primary homes and vacation properties. If you were to take out a home equity loan on your vacation property to fund renovations on that property, then the interest on that loan would still be tax-deductible. However, the interest is not deductible if you were to apply proceeds from the home equity of one property toward the repair of the other.

Reverse Mortgage

A reverse mortgage may be a viable option for financing a second home, but only if you’re aged 62 or older. These special government-sponsored loans allow you to borrow money from your home without requiring repayment until you leave/sell your home. These are attractive loan options that allow older borrowers to conserve their savings when making a home purchase.

Keep in mind that interest will continue to accrue on these loans while they remain outstanding and your balance will grow if you neglect to make any payments. If you pass away with a reverse mortgage outstanding, your heirs will also need to pay off your reverse mortgage if they wish to keep the home. Otherwise, they may be forced to sell the property to satisfy the outstanding balance.

Cash-Out Refinance

This option allows you to refinance your mortgage for more money than you owe, keeping the difference in cash. It is an ideal option if mortgage rates now are lower than you’re currently paying, since you'll be able to refinance your mortgage and cash out on equity at the same interest rate, essentially killing two birds with one stone.

Your monthly payments will likely increase as a result of the larger balance extracted from your cash-out refinance. You will also be responsible for closing costs here, whereas the closing costs on a comparable home equity loan or HELOC might be lower or covered by your lender in some instances. Borrowers attempting a cash-out refinance should be aware that they’re essentially resetting the clock on their existing mortgage, albeit at a different interest rate.

Loan Assumption

On occasion, you may be able to assume the mortgage from the sellers of the property, which means that you take over the payments of the mortgage loan that the seller has on the home. This is a great option if the seller already has an FHA or VA loan outstanding at a low interest rate. Second homes aren’t normally eligible for loans backed by the VA or FHA, so this can be an excellent low-rate option if you’re lucky enough to stumble across a vacation home with a government-backed mortgage outstanding.

The downside is that you’ll obviously need a bit of luck to find a second home with an owner who already holds a FHA/VA loan. The second issue is that the loan agreement will need to allow for a loan assumption, as not every lender is willing to accommodate this arrangement. Loan assumptions also are not permitted on most conventional mortgages. Those who qualify for loan assumptions may also need to put down a hefty down payment to buy out any existing equity interest that the seller has accumulated in the property.

401(k) Loan

401(k) loans allow you to borrow money from yourself and pay it back in monthly installments. These loans have the benefit of being "interest-free" in the sense that any interest owed will be repaid straight into your retirement fund. They are popular loan options for funding down payments, as these are one of the few places, aside from home equity, that people tend to have a significant amount of wealth saved up.

One of the biggest cons of 401(k) loans is that you’ll lose out on any interest that the borrowed funds could have earned had they remained in your 401(k) account. The required repayment period is also relatively short, which means you’ll have higher monthly payments to deal with, depending on how much you take out. Defaulting on a 401(k) loan could also result in any outstanding loan amounts being declared taxable by the IRS.

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