Using a Home Equity Loan for a Down Payment

If you have enough equity in your current home, you can use the money from a home equity loan to buy a second home. But it’s not always the best option.

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.

Getting together enough money for a down payment can be one of the biggest hurdles for homebuyers. Coming up with 20% of the purchase price isn’t easy, especially for first-time buyers. That’s why some turn to home equity loans to help fund their down payment.

What is a Home Equity Loan?

A home equity loan lets homeowners borrow against the equity they’ve built up in their current home. Equity is the difference between what your home is worth and what you owe on your mortgage.

For example, if your home is worth $300,000 and you owe $200000 on your mortgage, you have $100000 in equity. With a home equity loan, you can borrow a portion of that equity – typically up to 85% – in a lump sum.

Home equity loans come with fixed interest rates and set repayment terms, usually 10-30 years. You pay back the loan in fixed monthly payments, just like a mortgage.

Can You Use a Home Equity Loan for a Down Payment?

Yes, a home equity loan can be used for a down payment on a new home. The loan provides you with a lump sum of cash, so you can use the funds any way you want

Just keep in mind that you can only borrow up to 85% of your available equity So if you have $100,000 in equity, the maximum home equity loan would be around $85,000

Pros of Using a Home Equity Loan for a Down Payment

Tap equity without selling: Taking out a home equity loan lets you leverage your equity without having to sell your current home. This allows you to buy the new house while keeping the old one as a rental or second home.
Potentially lower rates: Home equity loans often have lower interest rates compared to other options like personal loans or credit cards. The national average rate is around 5-6%.
Fixed payments: Home equity loans have fixed rates and terms. Your monthly payment stays the same over the life of the loan, which helps with budgeting.

Cons of Using a Home Equity Loan for a Down Payment

Closing costs: You’ll pay closing costs of 2-5% to take out a home equity loan. This can add to your total costs.
Your home is collateral: If you default, the lender can foreclose on your home. This is riskier than with an unsecured loan.
New mortgage too: Don’t forget you’ll now have another monthly mortgage payment on the new home on top of repaying the home equity loan.

What to Consider Before Using Home Equity

Before tapping your home equity, make sure you:

Have at least 20% equity available
Can afford the new mortgage payment plus the home equity loan payment
Are prepared for the risk of putting your home up as collateral

Also consider:

How long you plan to keep the home equity loan (i.e. loan term)
If you need funds all at once or over time (HELOC may be better option)
Your credit score and ability to qualify

Alternatives to Home Equity Loans

If a home equity loan doesn’t work for you, some alternatives for down payment funds include:

Personal loan – Unsecured loan usually up to $100k
Borrowing from 401(k) – Allows you to borrow up to 50% of your balance
Family gift – Get gift funds from relatives; no need to repay
Down payment assistance programs – Check state/local programs

Steps to Getting a Home Equity Loan

If you decide a home equity loan is the right way to go to fund your down payment, here are the basic steps:

Check your home equity – Determine how much equity you have available to borrow against.
Compare lenders and loan options – Shop around with lenders like banks, credit unions, online lenders. Compare interest rates, fees, and terms.
Apply for the loan – Complete the application with your chosen lender. You’ll need info like your income, debts, credit score, and home value.
Get an appraisal – The lender will order an appraisal to confirm your home’s current market value.
Close on the loan – After approval, you’ll sign final paperwork and receive the loan funds, typically in 1-2 weeks.
Make payments – You’ll now make monthly payments on the home equity loan until it’s paid off.

Using Home Equity as Part of Your Down Payment

Many homebuyers use home equity loans to cover a portion of their down payment. For example:

Home purchase price: $400,000
Down payment needed: 20% = $80,000
Home equity available: $60,000
Additional funds needed: $20,000

In this case, the borrower could tap $60,000 of their equity via a home equity loan, and provide the additional $20,000 from savings or other sources.

Closing Thoughts

Tapping home equity through a loan or line of credit can be a smart way for some buyers to come up with the down payment on their next home. But make sure you consider both the risks and alternatives before moving forward.

Weigh the pros and cons carefully based on your specific situation. Don’t take on more debt than you can comfortably afford. With the right prep and budgeting, a home equity loan can be an effective way to finance your down payment and get you into your dream home.

using a home equity loan for a down payment

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.

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.

Use HELOC for a Down Payment on an Investment Property – Good Idea?

FAQ

Can you use your home equity as a down payment?

Potential for large down payment: Home equity loans can provide you with a large lump sum of money for a down payment on a second home. This large down payment may pay off in lower interest rates, lower monthly payments or reduced insurance premiums.

What should you not use a home equity loan for?

Don’t: Use it to Pay for Vacations, Basic Expenses, or Luxury Items. You have worked hard to create the equity you have in your home. Avoid using it on anything that doesn’t help improve your financial position in the long run.

Can you use a loan for a down payment on a house?

Technically, you can, but a personal loan isn’t a great option for purchasing a home or making a down payment in most cases. Instead, you’ll generally be much better off with a traditional mortgage. However, a personal loan might be a good option if you’re looking to purchase a mobile home.

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

The Bottom Line. Using your home equity to finance the purchase of a new home is a valuable financial strategy that can unlock new opportunities. It allows you to tap into the equity you’ve built in your primary residence to make your dream of owning a second property, whether for investment or personal use, a reality.

Can a home equity loan be used for a down payment?

Yes, if you have enough equity in your current home, you can use the money from a home equity loan to make a down payment on another home—or even buy another home outright without a mortgage.

Can I borrow against my home equity?

Borrowing against your home equity is a common option for homeowners.Here are a couple of ways to do it: 1.**Home Equity Loan**: Also known as a second mortgage, a home equity loan allows you to borrow

Can a home equity loan pay off a mortgage?

A home equity loan can be used to pay off your current mortgage, but this only makes sense if you can get a lower interest rate (as well as factoring in closing costs and fees) than your current mortgage. If you can, this will allow you to save on interest and thereby reduce your monthly payment. How to get a home equity loan?

How does a home equity loan work?

A home equity loan functions much like a mortgage where you’re provided a lump sum up at closing and then you begin repayment. Every month, you’ll make the same payment amount, which is a combined principal and interest payment, until your loan is paid off.