Buying a vacation home could make sense if you have a preferred vacation spot you frequently visit. The financial consideration of a vacation home purchase isn’t the same as booking a hotel room one trip at a time, though. This is a long-term expense you’ll need to figure out how to pay for.
If you’ve built up equity in your primary home, you could tap into it for a vacation home purchase. Doing so could minimize what you pay out of pocket to buy a vacation home, but consider whether using home equity to buy another property makes good financial sense.
How Using Equity to Buy a Vacation Home Works
There are two ways to think about using home equity to purchase a vacation home. The first is how you can access your equity; the second is what it can be used for.
There are three primary ways to pull equity from a home:
— Home equity line of credit
— Home equity loan
— Cash-out refinancing
All three can free up cash that you can use as you see fit to purchase a vacation home, says Carrington Carter, co-founder and president of real estate investment company McKinley Carter Enterprises. But each one can impact your financial picture differently.
A home equity line of credit, for instance, is a flexible line of credit that you can draw against as needed. An advantage of using a HELOC to buy a vacation home is that you may only have to make interest-only payments or have a low monthly payment for the initial draw period. But, Carter points out, HELOCs typically have a variable, rather than fixed, interest rate. If interest rates rise, that could increase the amount of interest you’ll pay. And after the draw period, you should expect to make full principal and interest payments.
[Read: Best Home Equity Loans.]
With a home equity loan, you’re getting a lump sum of money you can apply to your vacation home fund, and you’re more likely to get a fixed interest rate. Similar to a HELOC, you’d have your regular mortgage payment to make each month, along with a payment toward your home equity loan. That could require some budget adjustment to accommodate both payments.
A cash-out refinance 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 a single payment to manage going forward. That’s a plus, but if you extended your new mortgage term beyond the number of years you had left on your original mortgage, that could mean more interest paid over time.
In terms of how equity can be used to buy a vacation home, homeowners have some leeway.
“The beauty of the equity in your home is that it’s your money and can be used for what you see fit,” says Jeremy Sopko, CEO and co-founder of Nations Lending direct mortgage corporation. “A vacation home will generally require 10% to 20% for the down payment, so depending on the amount of equity you have, you can buy a home outright or use the equity in your primary home as the down payment.”
If you have a significant amount of equity — meaning enough to buy a vacation home outright or make a sizable down payment with money left over — you might also use some of it to make renovations or remodel your new getaway spot once the purchase is complete.
Should You Use Home Equity to Purchase Another Property?
The answer to this question depends on several factors, including the terms of your current mortgage and which method you plan to use for tapping equity. Sopko uses a cash-out refinance as an example.
“If your current mortgage has favorable terms, you may not want to refinance this loan at all,” Sopko says. “However, if the current market rate is lower than what you have on your primary mortgage, it’s possible to refinance your first mortgage, get cash and not have any additional cost associated with tapping into that equity.”
How much equity you have also matters, since it can determine which type of equity financing option you’re eligible for, if any.
Ann Thompson, retail sales executive-West, consumer lending, Bank of America, says, “If you’re taking out a HELOC, for example, the amount of available equity you have 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 your home’s appraised value. If you owe $100,000 on your mortgage and your home is appraised at $300,000, your LTV would be 0.33, or 33%. Depending on whether you’re using a home equity loan, HELOC or cash-out refinance to access your equity, lenders may require an LTV of 85% or less. In other words, you need to have at least 15% equity in the home.
Thompson says owning a second home can bring potential tax benefits, depending on the type of property purchased and how it’s used. But, she notes, owning a second home just for vacations is different from owning an investment property. “That difference can affect a buyer’s finances, including the taxes owed on the property and the type of insurance coverage needed,” she says.
[Read: Best Mortgage Lenders.]
Alternatives to Using Home Equity to Buy a Vacation Home
There are some other options for purchasing a vacation home that can leave you with your equity intact.
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 pull money from liquid savings, such as a savings account or money market account, you would want to be sure that you still have enough cash to cover emergency expenses or repair costs.
Or if you’re using tax-advantaged retirement plan assets to buy the home or make a down payment, there could be penalties. If you’re pulling money from a traditional individual retirement account or 401(k) before age 59½, you may have to pay a 10% early withdrawal penalty, along with ordinary income tax on the withdrawal. Not only that, but you’d be shrinking your retirement nest egg.
What to Consider Before Tapping Your Equity
Carter says that if you’re considering using home equity to buy a vacation home, think carefully about:
— How much equity you’ll need to buy the home and how much of it you’re willing to use.
— How much rental income the home could generate.
— Where a home equity, HELOC or potentially larger cash-out refinance payment fits into your budget.
— What other qualifications you’ll need to meet to access your equity.
For example, lenders will also take your credit score into account when you apply for a home equity loan, HELOC or cash-out refinance. A credit score of 700 or better should be good enough to qualify for any of those options, but if your score is lower, say around 620 or less, you may find it harder 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.
Aside from credit scores and LTV, lenders also consider your debt-to-income ratio. Carter says lenders typically set the range for acceptable DTI ratios at 43% to 50% for home equity borrowers.
[Read: Best Mortgage Refinance Lenders.]
You should also think about how owning a second home may impact your finances in general. Not only might you have two mortgage payments to manage, but you’ll also have to factor in things like property taxes, homeowners insurance and upkeep for a vacation property. When in doubt, talk over the options with your lender so you can decide if taking on a second home using your equity is the right move.
“Making your home’s equity work for your family is one of the true benefits of homeownership; however, there’s no blanket rule about how it should be used,” Sopko says. “With the numerous loan programs, loan types and vast amount of guidelines present in lending, a consumer who’s looking to purchase a vacation home should always contact a trusted mortgage expert first.”
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