Home equity loans are one of the most popular and common ways of purchasing a second home.
Homebuyers use these loans to eliminate or reduce their out-of-pocket expenses compared with other mortgages.
What's in this article?
However, as with any real estate purchase, these loans come with risks.
Read on to learn about home equity loans and the best way to navigate your way into a vacation home or investment property.
The best way to use a home equity loan
If you’re a homeowner who wants to purchase a second home, your current home will need to be of a greater value than the new property.
What’s more, you will also need to meet specific requirements established by a lender before you can sign on the dotted line.
Decide how much you want and need
Regardless of the lender, home equity loans limit the amount of equity you can draw from your current home. For most homeowners, you can access a maximum of only 85% of your current home’s equity.
Know what the lender will look for
Before you begin any home loan application process, it’s good to know what the lender will be researching when checking out your individual finances.
The value of your home will obviously be a significant factor. A lender can determine the value of your home by ordering an appraisal, a standard requirement in any approval process.
However, your personal financial information will be the ultimate deciding factor on how much of that equity you’ll be able to access.
A lender will check your gross income, credit score and any outstanding debts you may have such as credit card balances.
If it’s an investment property you’re interested in, the potential rental income you earn may also be a factor.
It’s good to look over your own financial markers before starting the application process to know where you stand before you get officially started.
Get quotes from multiple lenders
You can use any mortgage lender to take out a home equity loan, not just the lender who approved your current mortgage.
Shop around and get a few rate quotes from the various financial institutions available.
Make sure you compare each lender’s interest rates, fees, mortgage loan terms and estimated closing costs. It’s also possible to negotiate the mortgage rates and terms of the home equity loan to get a better deal.
Crunch the numbers
There are many different mortgage calculators available online to help you figure out what you can afford, your monthly payments and comparison calculators.
Compass Mortgage has several tools available including a mortgage payment calculator and a loan comparison calculator. They’re free to use and might help clarify your position.
Closing the loan
Once you’ve made your choice, make sure you understand the terms of the agreement—the interest rate, if the rate is fixed or adjustable, the amount of the down payment and the closing costs.
And remember, the federal three-day cancellation rule states you have three days (including Saturdays) to reconsider most signed home equity loan agreements. If the collateral is your primary residence, it’s possible to cancel without penalty.
Ready To Take Your Next Step?
Are home equity loans worth it for you?
Using a home equity loan has different requirements than your first mortgage.
Consider the pros and cons before purchasing a second home using a home equity loan.
Cons
Home equity loans can be beneficial, but each loan or refinance type is not always the best option for everyone’s situation.
Primary residence risk
Since you’re tapping into your current home’s equity, your primary home is used as collateral by accepting a home equity loan. As a result, your primary residence is at risk should your mortgage payments become too much.
Increase in monthly payments
Because you have taken on more significant expenses with a second home, you will see an increase in your loan payments.
Potentially, you’ll have two mortgages plus the home equity loan to repay. Consider, for example, in a worst case scenario such as a job loss or medical emergency, whether you will still be able to afford the loans.
Closing costs
Closing costs are a typical expense when using equity to purchase a new home, ranging from two to five percent of the entire loan amount. It’s also possible you could pay a higher interest rate when compared to a standard mortgage.
Pros
On the positive side, a home equity loan, particularly for a vacation home or second residence, can be the best financing option.
Cash flow
By using a home equity loan, you can keep your cash available that otherwise might have gone towards the home purchase. You can apply that extra cash towards other uses like:
- An emergency fund
- Other investments
- A larger down payment towards the second home, increasing your buying potential
- If your home’s value is great enough, you might even be able to purchase the second home with a lump sum of money—making you a cash buyer
Lower interest rates
Compared to other forms of borrowing, such as a personal loan or cash out refinance, home equity loans generally have a lower interest rate.
Of course, the rate you’re offered is often based on your personal financial situation. This is another reason to shop around with lenders.
Better chances of approval
Home equity loans are considered less risky to the lender than getting a separate mortgage for a second home.
That’s because the borrower is more motivated to avoid foreclosure on their primary residence than they would be on a second home or investment property (rental property).
No liens
Unlike a home equity line of credit (HELOC), which is a different product, a home equity loan doesn’t put a lien on your primary residence.
One lump sum of funds
A home equity loan is also different from a HELOC in another way. With a home equity loan, you get access to a lump sum of funds at once. A HELOC offers a revolving line of credit that you’d use like a credit card.
Using Home Equity To Buy Your Vacation Home?
Home equity loans are just one way to purchase a second home or vacation home. Refinancing could also give you the means to achieve second home ownership.
Having a vacation home away from your primary home can significantly benefit you and your family.
You’re also adding to your financial portfolio and possibly increasing your overall self-worth.
But, like every real estate transaction, we could all use some professional advice now and then—especially if this is your first time buying another residence for yourself.
If you want to explore your mortgage loan options, contact one of Compass Mortgage’s loan officers today.
Our team of specialists have the experience and passion to get our customers the best mortgage possible.
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