How to use your home equity to buy another house

Family spending time in their second home that they purchased using a home equity loan

Having easy access to funds while purchasing a second home is essential. However, you may be wondering where you can get the cash to put toward your next home purchase. One financing option is to unlock a portion of your existing home equity.

What is home equity?

Home equity refers to the portion of your home’s value you own outright. For example, if the current market value of your home is $400,000 and you have a balance of $200,000 on your mortgage, then you have $200,000 in home equity. If you’re looking to purchase a second home, you may be able to tap into this equity for a down payment.

Homeowners can borrow against their home equity using a traditional home equity loan, home equity line of credit (HELOC), or a cash out refinance. These borrowing options let you use your equity as collateral for a loan, which may result in a lower interest rate than other forms of borrowing like personal loans or credit cards.

Each type of home equity financing comes with unique features:

Home equity loan: A home equity loan is a lump sum of money you can borrow, using your home as security. These loans typically have a fixed interest rate and fixed monthly payments over a term of 10-30 years.
Home equity line of credit (HELOC): A HELOC is a line of credit with a monetary limit that you can access as needed. There is a fixed draw period during which you can withdraw funds and a fixed repayment period that usually lasts 10-20 years. Since HELOC interest can sometimes be variable and fluctuate due to economic conditions, monthly payments may increase as the repayment period progresses.
Cash out refinance: A cash out refinance replaces your current mortgage with a larger amount than you already owe. You can withdraw extra money from your home equity as cash and repay it with your mortgage in a single monthly payment. If you have a $100,000 mortgage and you want to borrow $50,000 to buy a second home, you could potentially refinance for $150,000 and combine both amounts into one loan.

Requirements for using a home equity loan to buy another house

Lenders typically consider several factors when deciding whether to approve you for a home equity loan:

CLTV: Lenders usually assess your combined loan-to-value (CLTV) ratio to determine the amount you can borrow. CLTV is calculated by dividing your current mortgage amount, your new loan amount, and any additional loans that you have against your home by the current value of your home. If your current property value is $400,000 and your combined loans total $300,000, your CLTV is 75%.
Credit score: Your credit score is another crucial factor for lenders. A higher credit score indicates you are likely to repay your loan on time and may result in lower interest rate offers.
Debt-to-income ratio: Lenders also look at your debt-to-income (DTI) ratio when considering your application for a home equity loan. Your DTI is calculated by dividing your monthly debt payments by your gross income. Lenders generally prefer a DTI of 43% or lower, meaning your monthly debt payments should not exceed 43% of your gross monthly income.
Proof of income: To qualify for a home equity loan, you might need to submit pay stubs, tax returns, bank statements, and other financial documents. Lenders want to see you have a stable source of income and can manage your loan payments.
Home appraisal: You may need a home appraisal to work out the current value of your home. This will help your lender determine how much equity you have in your home and how much you may be able to borrow.

You’ll also need sufficient equity in your property to be eligible for a home equity loan.

Depending on the lender you work with and the type of home financing you choose, available loan limits, CLTV requirements, and interest rates may vary. Researching and comparing different options will help you find the right product for your unique situation.

Discover® Home Loans offers low fixed rates on home equity loans up to 90% CLTV with $0 application fees, $0 origination fees, $0 appraisal fees, and $0 costs due at closing.

Step-by-step: Use your home equity to buy another house

Using your home equity to buy a second home may be a smart financial move if you’re able to manage your debt and repay your loans on time. However, you should carefully consider your financial situation and ability to repay before borrowing money. Follow these steps when using home equity to purchase a new house:

Step 1. Calculate your home equity: The first step is working out how much equity you have in your current home. To get an idea of what options may be available to you based on your available equity and desired loan amount, try using a loan amount calculator.

Step 2. Decide how much you want to borrow: The next step is to deciding how much you want to borrow against your home equity A tool like an affordability calculator may help you determine your budget.

Step 3. Consider your options: There are different options for borrowing against your home equity to finance a second home including traditional home equity loans, HELOCs, and cash out refinances. Compare the pros and cons of each one

Step 4. Apply for a home equity loan: Once you know how much you want to borrow, you can apply for a home equity loan to finance the purchase of your second home. You’ll need proof of income, and other financial information to support your application.

Step 5. Apply for a mortgage: If you require additional financing to buy another home, consider applying for a new purchase mortgage. Your mortgage lender will review your financial information again, and you may use the funds from your home equity loan to cover a down payment, closing costs, or other expenses.

Keep in mind that borrowing against your home equity can come with risks, such as foreclosure if you’re unable to make loan payments So, you’ll want to plan ahead and budget properly.

Couple researching how much home equity they have established as they use equity to purchase their second house

Home equity loans can provide you with a large lump sum of money for a down payment on a second house.

Advantages of using equity to buy another house

Using home equity to buy a new home can be advantageous since home equity loans are secured loans and might offer lower interest rates and higher borrowing limits than many unsecured personal loans. Here are some other benefits:

Capitalize on standing assets: By using home equity to buy a second home, you can pull from a stable source of money Withdrawing from certain other sources, such as long-term investments or a bank account, may possibly put a dent on your long-term financing goals.
Fixed rates can offer predictability: Home equity loan interest rates are fixed, so you know how much your payments will be every month. Use a monthly payment calculator to see how fixed payments work for you.
Potential for a large down payment: Home equity loans can provide you with a large lump sum of money for a down payment on a second home. By putting more money down, you could lower interest rates, monthly payments or insurance premiums.

Disadvantages of using equity to buy a second home

While low fixed interest rates, high borrowing limits and steady payment schedules can make home equity loans appealing when buying another house, there are some risks you need to know about.

You risk losing both homes: If you use a home equity loan to purchase your second home, you are putting both your primary residence and second home at risk of foreclosure. When you default on a loan, the bank might take your home and recoup the full value of the loan.
Funds from a home equity loan may not be tax deductible: Home equity loans (and HELOCs) may allow you to deduct interest payments on your tax return if the funds from the loan go toward substantial home improvements. However, when you use a home equity product to finance a second home, your interest payments are not eligible for tax deduction. Consult a professional tax advisor to learn.
You may owe more on your home than its market value: If the value of either of your primary or secondary home falls in a depressed market, you may own more on your mortgage and home equity loan than the properties are worth. This might not be a problem if you’re not planning on selling either home and can continue to afford monthly payments,. However, if you find yourself trying to sell a property, reduced market values may affect your ability to repay what you own.
You might not be able to refinance your first home: Having a second home loan on your primary residence may prevent you from refinancing your original mortgage loan. Some lenders may not allow refinancing until you repay the second loan.

Alternatives to using equity to buy another home

There are other ways to access funds to purchase a second home:

Retirement funds: Most retirement funds will charge you a penalty and fees for any early withdrawals you make, even when they go toward the purchase of real estate. However, if you accept paying these charges, retirement funds could provide an alternative to taking out a loan.
Personal loans: Like home equity loans, unsecured personal loans may let you finance a second home. However, most personal loans have higher interest rates and lower borrowing limits than home equity loans.

Closing thoughts: Using your home equity to buy a second home

Using your home equity to buy another house may be a way to achieve a brighter financial future if you can manage your debt and repay your loans on time. By following the steps outlined above, you could achieve your homeownership goals and create an opportunity to build long-term wealth. However, make sure you consider your financial situation and ability to repay before borrowing against your home equity. By doing so, you can minimize risks and make the most of your finances.

Please note: Discover offers home equity loans and mortgage refinance opportunities but does not offer HELOCs or purchase mortgages.