How Risky is Using My Home Equity to Buy Another House?
This is a question asked by many and it may be one you are currently asking. Real estate is said to be a great investment, whether you are living in it or using it for rental income. It can, though, be a tough industry to break into because it requires such a large initial investment. Most people do not have the money in the bank to purchase a property outright, so they borrow the money through mortgage loans.
While some stick with owning one home, others want to purchase a second one for various reasons. The most common way to do so is by using the equity you have in your first home, but not everyone is comfortable with this option. The big question is just how risky of a move it is. That is a question we hope to answer here, but let’s start with some basics before we dig into the deep stuff, shall we?
What Exactly Is Home Equity?
Equity in a home is simply the amount of house that you own. It is determined by figuring out how much the home is worth at that time and subtracting any debts that the home is tied to.
Let’s simplify. If you own a home that has a current fair market value of $120,000 and you owe $90,000 on your mortgage, your home equity is $30,000.
Your home equity is an asset that you can use as collateral for a loan. People borrow against their equity for a number of reasons, some of which include:
Paying off debts
Buying a car or buy another house
Sending their kids to college
Repairing their home
Any money you receive past the current mortgage amount can be used for pretty much anything, and there is more than one way to do it.
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Ways to Use Home Equity to Buy Another House
There are three basic home buying options borrowing against your home equity.
Home Equity Loan
A home equity loan is basically a second mortgage. You get the second mortgage based on the amount of equity you have in your home. It will likely have a fixed interest rate and the payment is usually fixed. Each month, you make both your mortgage payment and your home equity loan payment as they are two separate loans.
Home Equity Line of Credit
A home equity line of credit (HELOC) is similar to a home equity loan in that you get a second loan based on your equity. The difference is that a home equity loan is paid as a lump sum. A home equity line of credit is like a credit card- you can withdraw up to your limit for the set time period. The interest rate tends to be variable, and your payments depend on the amount you currently have out. As you repay, the money is replenished, allowing you to borrow it again.
Cash-Out Refinance
You have probably heard of refinancing. This is where you get a new mortgage to pay off your old mortgage, and you usually get a lower interest rate and can spread your payments out farther. Cash-out refinancing is basically the same except that you can borrow more than you owe on your current mortgage.
For instance, you may owe $80,000 on your current mortgage. With regular refinancing, you would get another mortgage for the $80,000. With cash-out refinancing, if you have enough equity in the home, you could get the second mortgage for a total of $120,000. The numbers, of course, depend on the specifics of your situation. If you end up choosing regular refinancing, we suggest taking a look at today’s rates in the table below:
One thing to remember with cash-out refinancing is that lenders will not give you the full amount of your equity. Instead, they usually only lend about 80 percent of it. A cash-out refinance also usually offers the lowest interest rate of these three options.
Lastly, a cash-out refinance is often confused with the other options. While they all have the same foundational purpose, they are loaned differently. A cash-out refinance is different from a home equity loan and a HELOC in that it converts your current mortgage into a bigger one, but it remains one mortgage where the other two mean that you pay two separate payments.
Things to Consider
Before moving on, there are some things that you need to think about as the answers could impact the risk you would assume using your home equity.
Do You Have Enough Equity in Your Home?
As mentioned a moment ago, you will not be able to borrow the full amount of your equity. So, you need to determine how much equity you have in your home and what 80 percent of that amount would be. Whatever the answer is, is that amount enough to buy another house and cover any repairs the house might need?
If the answer is no, you should probably wait until you have built up more equity. Otherwise, you may have to take out additional loans, and that is if you can get approved for additional loans. If you do not have enough equity for a new house, you may be getting into more debt for nothing.
In these calculations, you need to remember that there will also be fees and closing costs. The amount you can get through a cash-out refinance needs to be enough to pay these fees and closing costs, buy the house, make any necessary repairs, and- preferably- cover the first month or two in payments until you can move someone in.
What is the Purpose of the Second House?
When deciding whether you should use your home equity to buy another house, you should factor in the purpose of that house. Are you planning to rent it out? Are you keeping it to move into later or to use for vacations?
If you are going to rent it out, you should be expecting monthly income from it. This means that you will have some help on the mortgage payments- at least when it is being rented. Still, if you will be getting help, you will not have to come up with the full amount, which lightens your load a bit.
If you were not planning on renting it out, you will be responsible for the full payment yourself all of the time. This does not necessarily mean that you should not use your home equity to buy another house. You just need to consider it more carefully. No matter what you will do with it, that needs to factor into your decision.
It is also important to note that there are some restrictions when you are using your home equity to buy another house. If that second home is for you to live in, you cannot do it immediately. The borrower is typically required to continuing living for at least another year in their primary residence once they have taken out the loan.
This means that you cannot immediately sell your first home and move into your second, so you will have to cover all payments until that year is up. If your purpose is to use the second house as your home, you might consider renting it out during that first year so you will have help making your payments until you can live their yourself.
Can You Afford It?
Another thing that should factor in is whether or not you can afford to pay the payment. As stated previously, if you are not renting the house out, you will be paying the payment all by yourself. Even if you are renting it out, though, there will be times when the house is empty due to a transition between tenants.
Those times might only last a couple of weeks, but they could also last for months. Will you be able to afford the payment by yourself if there is no rental income coming in? You really need to be able to because if you cannot pay, you risk losing both homes. If you are going to use your home equity to buy another house, be sure that the payments are affordable enough to come out of your pocket if they need to.
Weighing the Options
Those two questions are very important to answer before you make any moves, but there are other factors as well. The following are the pros and cons to using your home equity to buy another house.
Pros
More Favorable Terms
There is often a very good chance that you can get a better rate and terms than you currently have. Perhaps when you got your first mortgage, the market was flooded with high-interest rates. Or maybe paying on your mortgage in a timely fashion has increased your credit score enough for you to qualify for a lower interest.
You might also be able to increase or decrease your repayment term according to your current needs and financial situation. Any of this can improve your mortgage situation overall, making it a smart move to refinance. If interest rates are currently higher than what you paid in the past, try to wait a while before refinancing. You want to put yourself in a better situation, not a worse one.
Puts Assets to Work
When you have equity in your home, it is an asset for you. However, it is an asset that is sitting still- not changing, not moving, not making you any money. If you buy another house with that equity, though- especially to rent out- you are putting that asset to work.
Cons
Increases Payments
One of the biggest factors to consider when it comes to using your home equity to buy another house is that you will be increasing your overall mortgage, which means that you are increasing your monthly mortgage payments. Putting yourself into more debt is usually not the best move to make.
Lack of Diversification
I said a moment ago that using your equity to buy another house is putting your assets to work for you. However, it is also putting all of your investment into one asset. They say you should not put all of your eggs in one basket. Using your home equity to buy another house is doing just that. There is no diversification. You might be better off putting your money into another type of investment.
Difficult to Liquidate
Let’s say that you decide that you cannot afford the payments, that you do not want to be a landlord anymore, or an emergency comes up that you really need cash for. These problems are not so easily fixable when all of your money is tied up in real estate.
It is one of the most difficult things to liquidate and it takes longer than most other assets. You can pretty quickly and easily sell your stocks or borrow against your retirement account. Selling a house might take weeks, months, or- in extreme cases- even years.
Potential Loss of Two Homes
Again, when you use your home equity to buy another house, you are risking your first home along with the second. What if you lose your job? What if you are unable to rent the residence out for a long period of time? The fact of the matter is that anything can happen, and if the wrong thing happens, you could lose not one but two homes.
Also, do not forget that if something goes wrong in the rental house, you will have to get it fixed. If you do not and it is a big issue, you may not be able to rent it out until it is fixed. Will you have the money to make repairs while not earning any rental income?
Tips for Using Home Equity to Buy Another House
If you feel like you should move forward with borrowing against your home equity, there are a few things you should take care of for the best results.
PERSONAL EMERGENCY FUND
First off, you should have an emergency fund for your regular monthly bills. You should aim for at least three to six months, but more is always better. This way, in case something does go wrong, you will have money socked away for your monthly expenses.
Create an Emergency Fund
Rental Expense Fund
In order to play it even safer, you should aim to have an emergency fund strictly for the rental expenses as well. Should one of those times occur that repairs need to be made or the rental is sitting empty for a while, this money can help you get by.
Choose the Best Time
There may or may not ever be a great time to use your home equity to buy another house, but some times are better than others. If you are currently or are about to go through a big change, such as moving, having a new baby, sending a child off to college, or starting a new job, adding another debt is probably not the best idea. You should wait until your life levels back out a little. Also, if interest rates are really high at the moment, then it is not a good time to make a big financial move.
Before you make such a huge move, take a look at what is going on in your life and in the market. If things seem a bit unstable at the moment, consider putting your plans on hold for a little bit.
Shop Around
If you choose to use your home equity, it is important that you make a wise choice as to the loan you are considering. Never take the first offer you get without doing your research. Take the time to shop lenders to find the best term and interest rate you can get. The first lender might be the best one, but you will not know that for sure until you shop around.
Conclusion
Choosing to use your home equity to buy another house is a very big decision to make. It needs to be considered carefully, weighing the potential impact on your life and your bank account. Try not to jump in head first until you have thought it through.
As it is such a risky move to make, it may be best that you talk it out with a friend as this may help you see things from a different perspective. You might also consider speaking to your financial advisor who can help you determine if you are in a good position to make such a big move.