There are a lot of ways you can capture equity to build wealth. For example, you can pay off higher-interest debt or make home improvements that ultimately increase the value of your house. You can start a business or you can even invest in the stock market where returns might be significantly more than the interest you pay on your loan.
Another question people commonly have is whether or not they can use their home’s equity to purchase another property, which we discuss below.
Can You Use a Home Equity Loan to Buy a House?
In short, yes. You can use a home equity loan to buy a house, but that doesn’t mean it’s always the right decision in every situation. Using home equity can be a way to buy a second home or an investment property with caveats.
A home equity loan is a second mortgage, giving you a way to access the equity you’ve built in your home. Home equity refers to the difference between what you owe and what your home is worth.
If you’re thinking about using your home’s equity to buy another house, there’s a distinction you need to first make. Are you buying a second home or an investment?
If you’re planning to buy an investment property, using a home equity loan can give you more liquidity and make it less expensive. Benefits of using equity to buy an investment property include:
• You can put more toward your down payment. A home equity loan is something you receive as a lump sum payment so that cash can go directly toward a down payment. You’ll be a more competitive buyer, which is essential in the current market, and you’ll get lower interest rates and monthly payments.
• It can be harder to finance a second property because there are more stringent down payment requirements, so a home equity loan can be a more affordable solution and also one that’s more convenient.
• A home equity loan is secured with collateral, which is your current home. As a result, you get the benefit of lower interest rates.
If you’re buying an investment property, using your home equity can be a good wealth-building strategy. If you’re buying a second home, you have to consider that it’s not going to bring in income like an investment. That means that you’re going to be tying your home up in a loan and then taking on another loan, so you need to be in a solid financial position to make this work.
The downsides of using equity to buy an investment property do exist. These include:
• You’re swapping an asset for a debt. You’re taking the part of your home that you own, and then you’re putting it into a loan. Ultimately, no matter the specifics, you will have higher debt, so is that what you want?
• You’re vulnerable to housing market shifts, even more so when you own two properties instead of one. You’re doubling your risk if something happens in the housing market. For example, if the value of either of your properties goes down, you might owe more on your home equity loan and your mortgage, overextending you.
• If you were to default on your loan, you could lose both properties.
• You might end up having three mortgages but only two homes. Most home equity loans are second mortgages, so you have to combine this with the loan you’ll need for your second home, meaning three mortgages.
• Another downside you’ll have to weigh is the fact that interest payments on your home equity loan will probably not be tax-deductible because of 2018 changes in tax codes.
The big takeaway here is that, yes, using home equity to buy a second home is an option and sometimes a very good one. At the same time, there are risks and it’s not always the right decision, so you need to go over the details in your specific situation carefully.