How You Can Use Home Equity to Buy Another House

American homeowners were sitting on a record $9.9 trillion in so-called “tappable equity” at the end of 2021 following a boom in housing prices last year, according to data firm Black Knight. All that equity represents an enormous pool of cash that homeowners can turn to if they plan to purchase a new property.

Tappable equity is the amount people can borrow while still holding at least 20% equity in their homes. Homeowners can access the funds through tools such as home equity loans, home equity lines of credit or cash-out refinances.

But is it wise to use a home equity loan — or another method that draws on your home equity — to help finance the purchase of a second home? As with any financial strategy, there are pros and cons to consider before taking the plunge.

[Read: Best Home Equity Loans.]

What Are the Pros of Using a Home Equity Loan to Buy a New Property?

A home equity loan might be a particularly attractive way to tap your equity right now. Sometimes called a second mortgage, this type of loan is a sum of money you borrow from a lender using your home as collateral. Such loans typically have fixed interest rates, according to the Consumer Financial Protection Bureau. Their terms are often between five and 30 years.

A home equity loan can provide enough cash for you to make a larger down payment on the new property, which may help you get a lower rate. It could also help you meet down payment requirements — you’ll likely need to make at least a 15% to 20% down payment to get a rental property, for instance.

Home equity loans can also provide an advantage over HELOCs in the current climate because they generally have fixed interest rates, while HELOCs have variable rates. Although HELOCs tend to have lower interest rates than home equity loans, the Federal Reserve recently raised interest rates by a quarter-point and has announced plans for several additional increases throughout the rest of 2022 and into 2023.

“I would not use a HELOC for anything now in this rising-rate environment,” says B. Kelly Graves, senior vice president and financial advisor at Wealth Enhancement Group in Charlotte, North Carolina. In fact, Graves says he would only recommend clients pursue fixed-rate loans and mortgages this year because of the likelihood of rising rates.

Having a fixed rate in a rising-rate environment gives you budgeting “predictability,” says Rob Cook, vice president for marketing, digital and analytics for Discover Home Loans. You can build a budget to make consistent monthly payments over a set amount of time.”

In addition, using funds from a home equity loan to purchase an additional home can be a better choice than depleting funds in a stock portfolio or savings account. Keeping investments or key savings intact may leave you better positioned to cover emergency expenses or work toward another financial goal.

“We like using real estate equity to buy real estate for diversification purposes,” says Dennis R. Nolte, a financial advisor and vice president at Seacoast Investment Services in Winter Park, Florida. “Real estate is usually illiquid, so selling stocks to buy real estate is generally not what we recommend.”

Lisa A.K. Kirchenbauer — a certified financial planner and founder and president of Omega Wealth Management in Arlington, Virginia — says she is using her own home equity to purchase a lot in Sun Valley, Idaho, and some of her clients have also tapped home equity to buy a second home when it makes financial sense. “If you don’t have cash lying around or don’t want to sell investments to come up with cash for a purchase, utilizing the equity in your home for another home or land can be a good option,” Kirchenbauer says.

[Read: Best Mortgage Lenders.]

What Are Potential Cons of Using a Home Equity Loan to Buy a New Property?

Putting money into real estate can be worthwhile. “What makes real estate a great investment is that you can put 20% to 25% down, but you get 100% of the appreciation,” says Mark K. Rylance, a CFP and co-owner of RS Crum in Newport Beach, California. However, before pursuing a home equity loan to purchase a new home, you need to understand the potential downsides.

Using home equity to purchase another property can become risky if market conditions or your personal circumstances change. If you run into unexpected costs, or if you simply experience a reduction in your income after losing your job or having a rental unit sit vacant for a period, “your ability to service the debt could become a serious problem,” Rylance says.

If you are unable to repay a home equity loan, the consequences can be severe. “You are putting both your primary residence and second home at risk of foreclosure,” Cook says.

Also, if you plan to refinance the mortgage on your primary residence, having a home equity loan attached to it can complicate matters. “Some lenders will not allow refinancing until the second loan is completely repaid,” Cook says.

You should also be aware that the 2017 Tax Cuts and Jobs Act restricted homeowners’ ability to deduct the interest on home equity loans and HELOCs from their taxable income, and consumers cannot deduct home equity interest when they use the equity to buy a second home. This restriction is in place through 2026.

How Much Can You Borrow With a Home Equity Loan?

The amount of money you get in a home equity loan will depend on your circumstances. To determine how much you can borrow, lenders typically look at your combined loan-to-value ratio, or the total of your mortgage balance, the new loan, and any additional loans that you have against your home divided by the current value of your home, Cook says.

So, if the current value of your home is $400,000 and your combined loans total $300,000, your CLTV is 75%. “Many lenders will only offer home equity loans for a CLTV up to 80%,” Cook says.

Alternatives to Home Equity Loans

If you run the numbers and find a home equity loan does not make sense for you, other home equity options are available.

For example, a HELOC is a revolving line of credit — like a credit card — that you can use to finance other purchases, including a new home. As mentioned, though, rates attached to HELOCs are typically variable, so your payment might change over time and can increase in an atmosphere where interest rates are heading higher.

A cash-out refinance is another alternative to a home equity loan. With a cash-out refinance, you take out a new loan that is bigger than the amount that is currently remaining on your mortgage. The extra cash then can be used to purchase the second home.

However, Nolte cautions that the rates attached to a cash-out refinance typically are higher than you would expect to pay on something like a home equity line of credit.

Or, if you are fortunate enough to have a large amount of money squirreled away, you can use that. “If you have cash sitting around, of course that would be better,” Kirchenbauer says. “It isn’t earning much and you don’t have to pay interest.”

All of these options have pros and cons, just like home equity loans. For some borrowers, tapping home equity to purchase a new property will make sense, but be sure to consider your financial situation to decide whether doing so is right for you.

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How You Can Use Home Equity to Buy Another House originally appeared on usnews.com

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