Yes, you can use your equity from one property to purchase another property, and there are many benefits to doing so. Home equity is a low-cost, convenient way to fund investment home purchases. If you live in a stable real estate market and are interested in buying a rental property, it may make sense to use the equity in your primary home toward the down payment on an investment property.
- Can I Use Home Equity to Buy Another Home?
- Disadvantages of Using Home Equity to Buy a Home
- How to Buy a House Using Home Equity
- Other Ways to Finance Investment Properties
Can I Use Home Equity to Buy Another Home?
If you're looking to buy an investment property, leveraging equity in your existing home is often the simplest and least expensive option in your toolkit. Home equity products feature some of the lowest consumer rates on the market because they are secured by real property—a high-quality form of collateral.
Home equity loan providers will often offer terms that are far better than anything you can secure on a similar personal loan. Below, we've provided a more detailed look at the advantages and disadvantages of home equity financing for new home purchases.
When buying a house, it's a better idea to use your home equity in the form of a loan or line of credit. This is because withdrawing funds from other sources like your investment portfolio, an IRA disbursement or your cash savings will detract from your long-term earnings and savings.
There's also the risk that your property purchase fails to pay for itself or even decline in value. In this case, not only would you have lost out on the potential earnings in your investment account, you would also have taken a loss on the principal.
Tapping into home equity instead of your standing assets allows you to fund home purchases at a discounted rate while your property and remaining assets continue to appreciate in value. You achieve a lower interest rate than with a personal loan, and you don't have to divert money from existing investments. Home equity financing allows you to tap into a part of your net worth that is otherwise difficult to utilize.
Because lenders spend less time and effort originating home equity loans and home equity lines of credit (HELOCs) than they do on first mortgages, they come with lower fees and closing costs. Home equity products also have lower average interest rates than other loan types since they're secured by high-quality collateral in the form of real estate.
Homebuyers might also negotiate more favorable purchase terms with home equity financing, which effectively works like a cash offer from the seller's perspective. Sellers appreciate the fact that you’re not beholden to a mortgage lender's timetable for financing. Finally, lenders often cover the closing costs on home equity products like HELOCs, which is especially useful for homebuyers trying to conserve cash.
Improve Cash Flow
Your rental income and mortgage payments don't change from month to month, so having a smaller monthly payment increases the portion of your rental income that’s considered net profit. This is desirable if market rents drop for any reason—you'll be less likely to need to sell your property because of trouble making payments.
For income-generating investment properties, creating as much positive cash flow as possible depends on the size of your down payment. By using your equity from another property to either increase your down payment or buy the property outright, you increase the monthly cash flow from your new property.
While new tax laws in 2018 removed most of the deductions for home equity loans (in effect from 2018-2026), that interest is still tax-deductible for loans of up to $750,000 (as of August 2018), if you access your equity through a cash-out refinance of your first mortgage. This method allows you to deduct more interest than if you had obtained separate financing for each property.
Disadvantages of Using Home Equity to Buy a Home
Despite the advantages, leveraging your home's equity to purchase another property ties up funds in an asset that is difficult, time-consuming and costly to liquidate quickly in an emergency. Once the equity is used to buy another home, it can be rebuilt slowly by repaying the loan. However, the only ways to recover it quickly are by refinancing or selling the new property, which may or may not be profitable at the time.
Before 2018, the interest paid on home equity loans was deductible from your income tax returns. Going forward, home equity loan interest can only be deducted when you use the loan to buy or improve the property you put up as collateral. This means that interest you pay on funds used to purchase investment properties will no longer be deductible unless you get a cash-out refinance.
Taking out home equity to buy a second home also increases your exposure to the real estate market, particularly if your investment property is in the same market as your primary home. It’s important to consider the risks of investing in real estate and recognize that property values aren’t guaranteed to increase over time. When markets decline, over-leveraged homeowners face a higher risk of being underwater on multiple properties.
How to Buy a House Using Home Equity
You can cash out your home equity through one of many financing methods including a HELOC, fixed-rate home equity loan, cash-out refinance or reverse mortgage. Your ideal approach will depend on your unique circumstances.
Home Equity Line of Credit (HELOC): A HELOC is an open-ended credit line tied to the equity in your property. Much like a credit card, you can borrow and repay funds while the line remains open. HELOCs have an initial draw period determined at the outset of your loan and a repayment period that's usually fully amortizing.
This is the ideal option if you’re interested in “property flipping” because it allows you to purchase the property, pay for renovations and repay the line when the property sells.
Second Mortgage (Home Equity Loan): Also referred to as a fixed-rate home equity loan, second mortgages are lump-sum payments that have set terms for repayment. These usually carry fixed rates and are paid back in full by the end of the loan term, although interest-only home equity loans and balloon payments do exist.
The fees on home equity loans are similar to what you see on HELOCs. The benefit of second mortgages is the predictability of their repayment schedules. While variable-rate HELOCs offer flexibility for borrowers who wish to draw on them again, home equity loans are ideal for down payments on rental properties that don't need any work.
Cash-Out Refinance: A cash-out refinance can accomplish two objectives:
- Refinance your remaining mortgage balance at the market interest rate
- Rewrite the balance of your loan for a larger amount, which allows you to draw cash against your property at a discounted rate
This creates a single, first lien mortgage on just one property with the added benefit of a lump-sum payment at closing. As noted above, first-lien mortgages are not subject to the revised tax law and are still tax-deductible if you owe less than $750,000, unlike a second mortgage. As of 2018, the interest on home equity and HELOC products are no longer tax-deductible unless used for home improvement.
If market rates are lower than the rate of your current mortgage, then you also have the opportunity to reduce your interest rate. However, interest rates on cash-out refinances are typically higher than standard refinancings, so it may not make sense to do a cash-out refinance depending on the rate of your new loan.
Reverse Mortgage: If you're 62 or older and own a significant portion of your primary home, you should consider a Home Equity Conversion Mortgage (HECM), also known as a reverse mortgage. This allows you to tap your home equity as either a lump sum or credit line and doesn't require repayment until you leave your property.
Reverse mortgages often entail higher fees than traditional mortgages, but they offer greater flexibility in monthly cash flows. This makes them ideal for a down payment on a vacation home without requiring any initial cash outflow. Keep in mind that interest will continue to accrue over time while you reside in your home.
Reverse mortgages may pose an issue if you intend to pass on your home to any heirs, as repayment requirements are triggered once the last borrower passes away. This can force your heirs to surrender your home if the loan amount exceeds the property's appraised value. However, heirs can never owe more on a reverse mortgage than the value of the home, so borrowers can take comfort in knowing that their exposure is capped.
Other Ways to Finance Investment Properties
Retirement accounts, like 401(k)s, sometimes allow you to take out a loan against them for the purpose of purchasing a home. These are known as "401(k) Loans" and are offered under employee-sponsored retirement plans. All money dedicated toward repaying these loans goes straight back to your retirement account with interest, without any prepayment penalty or costs, under certain circumstances.
The downside of 401(k) loans is that you forgo any interest that you could've earned on your account, had you not taken out your loan. Additionally, losing your job while the loan is outstanding could be grounds for immediate repayment or could cause the loan to become taxable if left unpaid.
Personal or signature loans are another viable option and don’t require any collateral, but the interest rates are generally higher than on collateralized loans like mortgages and auto loans. Unless they're paid off quickly, borrowers can expect to pay significantly more in interest than they would on a similar home equity products.