Buying a second home often has more restrictions than a primary home purchase. Simply put, the mortgage on any home other than your primary home is a high risk. What mortgage would you be more likely to pay if times got tough? Of course, it is the mortgage on your primary home. You need a place to live full-time rather than just for vacations or other reasons. For this reason, many lenders require higher down payments on other homes. This way you have more “skin in the game.” With a lower risk, lenders can afford to write more loans. But how do you get the money to put down on a home other than the one you live in? One easy way to get the higher down payment is with a home equity line of credit on your primary home.
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What is a Home Equity Line of Credit?
First, let’s look at the home equity line of credit. This is a second loan on your primary residence. It is the money a lender allows you to tap into rather than leaving it as your investment. For example, if your home is worth $300,000 and your first mortgage equals $100,000, you have $200,000 in equity. If you want to purchase a second home, you can tap into that equity to put a down payment on the home purchase. Usually, lenders maximize the amount you can take out at 85%, although some go higher or lower. In this instance, you could have up to $170,000 for the home purchase.
Why the HELOC is not Risky
You might wonder why lenders look at the down payment from a HELOC as less risky than any other method. Because the mortgage is on your primary home, they know you will do whatever you can to make the payments on time. On the other hand, if you were to put less money down on the second mortgage and borrow the remaining funds, you would put the lender at higher risk. Because the funds pay for the second home, if times got tough, you would likely just walk away from that property. This would leave the lender with a home and a big loss in their portfolio. This is why using the funds from the HELOC poses a much lower risk to lenders. They do not have to worry about the loss as much.
The HELOC is Inexpensive
One of the largest benefits of the HELOC is how inexpensive it is compared to other loan programs. The closing costs and even the work involved in the home equity line of credit is much less intense than a first mortgage. Most borrowers get away with very few closing costs on the HELOC because there is no title work or a lot of processing to do. In many cases, you do not even need a new appraisal – the lender can use an automated valuation or a drive-by appraisal. Both of these require less work and most importantly, less money.
The Benefits of Using a HELOC to Buy a Second Home
Everyone wants to know what the right answer is for them. Are there any benefits of using the HELOC to buy a second home? Luckily, there are quite a few:
- HELOCs are easy to qualify for, especially if you use your current lender. If you do not have to re-qualify for the loan, you can get the home equity line of credit in a short amount of time.
- You can likely write off the interest on the home equity line of credit on your income taxes, furthering the benefit of using it to gain money for the down payment on a second home.
- HELOCs are often easier to qualify for than a mortgage on a second home. Because the HELOC secures your primary residence, the likelihood of you paying it is much higher.
- Interest rates on home equity lines of credit are often lower than interest rates on second homes. This makes the payment more affordable.
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The Downsides of the HELOC
Of course, there are disadvantages of using a HELOC to purchase a second home. First and foremost, you put your primary home at risk. Because you borrow money against the home you live in, you stand the risk of foreclosure on this home. The only way to avoid this is to avoid getting in over your head. Do not borrow too much and make sure the payment is affordable right off the bat.
Another downside is the fact that you put all of your money in one investment. As we all saw a few years ago, the real estate industry can decline fast. If all of your money is invested in your homes, you stand to lose a lot of money. The best practice is to diversify your funds. If you can borrow some money to buy a second home, but also invest money in other vehicles, you get the best of all worlds.
Of course, only you know what is right for you. If you get a great deal on a HELOC and want to purchase a second home – go for it! Just make sure you know the full impact of the future payment. Figure out how it fits into your finances now. This way you can prepare for the future. Just because a HELOC has interest only payments for the first ten years, does not mean it does not change. In another 10 years, which comes up quicker than you think, you will owe the full principal and interest payment. Because the interest rates can fluctuate, you could find yourself with a much higher interest rate than you anticipated. Planning for the future and really considering your options can help you make the decision that is right for you.