Should You Use a Home Equity Loan for a Down Payment on a Second Home?

Suppose you own a home and can afford a worthwhile investment. You might consider purchasing a second property, which can generate additional income or serve as a vacation getaway. 

Homeowners often borrow against their home’s equity to pay for renovations like solar panels or consolidate debt. But a home equity loan or a home equity line of credit can also be used to fund a down payment on an investment property. Still, it’s worth considering the trade-offs when you borrow against your home’s equity. If you use your primary residence as collateral to secure a home equity loan and you can’t make payments, you risk losing your property.

Pros and cons of using a home equity loan as a down payment for a second home

Though you can use your current home equity to buy another home, always weigh the advantages and disadvantages. Generally speaking, you should be extremely cautious when using your first home as collateral to fund a down payment on a second property. 

Home equity loan vs. HELOC: What’s the difference?

There are two main types of home equity loans to choose from. A standard home equity loan has fixed interest rates for the entirety of the loan and provides you with a lump sum of cash upfront. A home equity line of credit, or HELOC, functions more like a credit card that you make continuous withdrawals from. Unlike home equity loans, HELOCs have variable interest rates that rise and fall according to economic conditions.

Home equity loans can have repayment periods of up to 30 years, which helps you keep your monthly payments low over time. HELOCs usually allow you to make interest-only payments for the first 10 years, during what’s called the draw period, which means you can make much lower monthly payments for an extended period of time.

How to use home equity as a down payment for a second home

To use a home equity loan or a home equity line of credit for a down payment on a second home, follow the steps below.

1. Determine how much equity you have 

Your home equity is the difference between what you still owe on your mortgage and the current appraised value of your home. It’s expressed as a percentage of your home you’ve already paid off. For example, if you owe $300,000 on your mortgage, and your house is worth $500,000, then you have $200,000, or 40% equity in your home.

2. Figure out how much you need to borrow 

Then, determine how much of your home equity you can borrow against. You have to calculate your loan-to-value, or LTV, ratio, which is your outstanding mortgage balance divided by your home’s current appraised value. The calculation for that $500,000 property would be: 

$300,000 / $500,000 = 0.60

This means you have a 60% LTV ratio. Lenders will typically let you borrow between 75% and 90% of your available home equity. To determine that amount, do the following calculation, which assumes a lender will let you borrow up to 85% of your home equity:

($500,000 [current appraised value] x 0.85 [maximum equity percentage you can borrow]) – $300,000 [outstanding mortgage balance] = $125,000 [amount the lender will let you borrow]

Make sure you qualify for a large enough home equity loan to cover your down payment. Most lenders require at least a 15% to 20% down payment to buy a second property, which is much higher than for a primary residence. 

3. Prepare the application

You’ll need to have your financial paperwork ready for your mortgage lender to review. That means showing proof of adequate income and stable employment through documents such as tax returns, pay stubs and W-2s. You’ll also need the paperwork for your existing mortgage showing that you’ve been making consistent, on-time monthly payments. 

Whether you’re approved depends on factors such as how much equity you have in your home, your credit score (700 and higher will get you the best rates) and your debt-to-income, or DTI, ratio. Lenders typically like to see a DTI of 36% or less, but no higher than 43%.

4. Compare lenders and rates

The more banks and lenders you interview, the better your chances are of finding the lowest rates and fees available. But keep in mind that not all lenders allow for a home equity loan to be used for the down payment on a second home.

Be sure to read the fine print. Some lenders may offer a lower interest rate but charge high fees that cancel out any savings on interest. Other banks offer preferred rates to existing or new customers willing to open a checking account.

5. Select the best offer

Once you’ve interviewed multiple lenders, choose the home equity loan with the most favorable rates and terms for your situation. If you can comfortably pay off your loan in 10 years, for example, you can choose a lender that offers a lower interest rate but a shorter repayment period. If you need breathing room in your budget over the next few years, you may want to choose a HELOC so you can make interest-only payments until your budget can afford higher monthly payments.

6. Obtain funds and make the down payment

Receiving your funds can take anywhere from two weeks to two months. If you choose a home equity loan to buy a second property, the entire amount of your loan will be disbursed to you upfront. If you take out a HELOC, you can start making withdrawals as needed. Depending on your lender, you can typically access your HELOC funds through checks or a debit card provided by the lender.

Is it a good idea to use home equity to buy a second home?

You should only use a home equity loan to buy a second home if you can afford multiple mortgage payments over the long term. An investment property can generate income and pay for itself when managed responsibly, but there will always be economic factors involved that are out of your control. If, for example, a renter moves out, can you afford to cover the mortgage payment on your own for a few months while you find a new tenant? If you lose your job, do you have enough savings to stay current on your monthly payments until you find a new role?

“Whether your home is paid off or not, tapping home equity isn’t free money and it’s not the same as going to the ATM and withdrawing money from your account,” says Greg McBride, chief financial analyst for Bankrate. “This is borrowing, which must be repaid with interest, and it puts your single largest asset on the line in the event of default. That doesn’t make it a bad option, just one to go into with both eyes open.”

In addition to the expense of a down payment and new monthly mortgage payment, don’t forget about all of the other costs associated with buying a new home. You’ll need to furnish the home, as well as take care of its maintenance and pay property taxes.

Other ways to cover a down payment for a second home

If you want to purchase a second home, there are alternative financing options aside from borrowing against your home equity that don’t require risking eviction.

• Personal loan: Interest rates for personal loans tend to be higher than interest rates for home equity loans because they aren’t secured by your property, which means lenders have less recourse to recoup their funds if you stop making payments on your loan. 
• Cash-out refinance: A cash-out refinance is when you take out a new mortgage to replace your existing mortgage to receive more favorable rates and terms. You receive a lump sum of cash that is then added to the balance on your new mortgage. 
• 401(k) loan: Some 401(k) plans allow you to borrow up to 50% of your retirement account balance, but you must repay the loan within five years. If you can’t replenish the funds in time, you’ll face IRS penalties, canceling out the benefit of the 401(k) loan.
• Wait and save: If you aren’t rushing to buy a property, consider waiting and saving the old-fashioned way. You can put your savings into a high-yield savings account or an interest-yielding account while you build up the funds to cover a down payment, avoiding exposing your home to foreclosure.