How to use equity to buy a second home
Whether it’s for a cottage, a vacation home or a rental property, using your home’s equity can be an excellent way to buy that second home you’ve been dreaming of.
“Potential buyers may not have the cash they require to pay for an asset like a second home in part or in full,” says Maxine Crawford, a mortgage broker with Premiere Mortgage Centre in Toronto. “They may have their money tied up in investments that they cannot or do not want to cash in. By using home equity, however, a buyer can leverage an existing asset in order to purchase in part or in full another significant asset, such as a cottage.”
What is home equity?
Home equity is the difference between the current value of your home and the balance on your mortgage. It refers to the portion of your home’s value that you actually own.
You can calculate the equity you have in your home by subtracting what you still owe on your mortgage from the property’s current market value. For example, if your home has an appraised value of $800,000 and you have $300,000 remaining on your mortgage, you have $500,000 in home equity. If you’ve already paid off your mortgage in full, then your home equity is equal to the current market value of the home.
What is a home equity loan?
A home equity loan (sometimes called a second mortgage) is when a home owner borrows money using the equity they’ve built up in their home as collateral for the new loan. Equity is the difference between the current market value of the property and the balance owing on the mortgage. Typically, home owners can borrow up to 80% of their property’s value, including any balance remaining on the first mortgage.
How to use equity to buy a second home
To buy a second property using home equity, you borrow money from a lender against the equity—meaning you use the equity as leverage or collateral. There are a variety of ways a home owner can do this.
Mortgage refinance: When you refinance your mortgage, you replace your existing mortgage with a new one on different terms, either with your current lender or with a different one (when switching lenders, you may have to pay a prepayment fee, unless your mortgage was up for renewal). When refinancing, you can get a mortgage for up to 80% of your home’s value. Refinancing your mortgage allows you to access the capital needed to buy a second home.
Home Equity Line of Credit (HELOC): A HELOC works like a traditional line of credit, except your home is used as collateral. You can access up to 65% of your home’s value. Interest rates on HELOCs tend to be higher than those on mortgages. However, you only withdraw money when you need it, and you only pay interest on the amount you withdraw, unlike with a second mortgage or reverse mortgage.
Second mortgage: This is when you take out an additional loan on your property. Typically, you can access up to 80% of your home’s appraised value, minus the balance remaining on your first mortgage. Second mortgages can be harder to get, because if you default on your payments and your home is sold, the second mortgage provider only receives funds after the first mortgage lender has been repaid. To compensate for this added risk to the second lender, interest rates on second mortgages tend to be higher than for first mortgages.
Reverse mortgage: Only available to home owners who are 55 or older, a reverse mortgage allows you to borrow up to 55% of your home’s equity, depending on your age and the property’s value. Interest rates may be higher than with a traditional mortgage, and the loan must be paid back if you move or die. You don’t need to make any regular payments on a reverse mortgage, but interest continues to accrue until the loan is repaid.
Options for leveraging equity in your home
To summarize, these are your options for pulling equity out of your home. The option you choose impacts how much you equity you can access, the type of interest rate you can get (i.e., a fixed rate, variable rate, or both), and when and how the money is deposited into your account.
| Credit limit | Interest rate options | Financial impact | Access to money | |
|---|---|---|---|---|
| Refinance your home | 80% of your home’s appraised value (including current mortgage balance) | Fixed or variable rate | Interest rate on your initial mortgage may change, or you may pay a different rate on the refinanced portion of your mortgage | Lump sum deposited to bank account |
| Second mortgage | 80% of your home’s appraised value (including current mortgage balance) | Fixed or variable rate | Interest rate is generally higher than your first mortgage | Lump sum deposited to bank account |
| Home equity line of credit (HELOC) | 65% to 80% of your home’s appraised value | Variable rate only | Rate and interest may change based on fluctuations in the lender’s prime rate | Revolving. Access like bank account |
| Reverse mortgage | 55% of your home’s appraised value (including current mortgage balance) | Fixed or variable rate | Interest rate is generally higher than a traditional mortgage | One lump sum or in installments |
How soon can you pull equity out of your home?
Mortgage lenders have different policies regarding how long a home owner must wait to refinance after purchasing their home, Crawford says. Some have a set waiting period of one year or more, whereas others decide on a case-by-case basis.
While there may be no hard-and-fast rules about how long you have to wait to draw on your home’s equity, to pull equity out, you must first build it up. The longer you make payments on your mortgage, the more equity you’ll have. It’s also important to take into account the time it can take to apply for a home equity loan. There are usually numerous steps involved, such as applying, having your home appraised, getting a credit check and so forth, so your access to the money will not be instantaneous and you can generally expect to wait anywhere from a few hours (for alternative lenders) to a few weeks.
Should you use home equity to buy a second home?
Before deciding whether or not to use your home’s equity to buy a second home, it’s important to take a careful look at the potential benefits, as well as the possible downsides.
“Using home equity could allow someone to build their net worth and improve their overall financial strength,” says Crawford. However, the mortgage broker also emphasizes that there are some potential drawbacks to using equity, including that the additional financing on the home increases monthly expenditures and could negatively impact a home owner’s overall lifestyle.
What’s more, home owners will likely incur costs when setting up financing. And, “If the primary residence is sold, any financing must be paid out in full, including any financing used for the purchase of the second home,” says Crawford. “This could significantly reduce funds available for other purchases, such as investments, and also affect estate planning goals.”
Read more about buying a second home:
- It’s possible to be a first-time home buyer twice—here’s how
- How financially viable is your rental property?
- Should you buy a vacation property?
- How much of a down payment do you need on a second home?
- Mortgage rules when buying a second property in Canada
What does the * mean?
If a link has an asterisk (*) at the end of it, that means it's an affiliate link and can sometimes result in a payment to MoneySense (owned by Ratehub Inc.) which helps our website stay free to our users. It's important to note that our editorial content will never be impacted by these links. We are committed to looking at all available products in the market, and where a product ranks in our article or whether or not it's included in the first place is never driven by compensation. For more details read our MoneySense Monetization policy.
The post How to use equity to buy a second home appeared first on MoneySense.
No comments