Can You Use a HELOC as a Down Payment?

Navigating home financing often leads to questions about leveraging existing assets. One common inquiry is whether a Home Equity Line of Credit (HELOC) can serve as a down payment for a new home. While possible, this approach introduces financial and underwriting considerations. Understanding these aspects is important for anyone considering this financing strategy.

Using a HELOC for a Down Payment: The Basics

A Home Equity Line of Credit (HELOC) provides a flexible financial tool by accessing equity in an existing home. A HELOC functions like a revolving line of credit, similar to a credit card, but it is secured by your home’s equity. Borrowers can draw funds as needed, up to an approved limit, during a specified draw period, typically 5 to 15 years. During this period, borrowers often make interest-only payments.

The mechanism involves drawing money from the HELOC on your current property and applying those funds toward the down payment on a new residence. This strategy appeals to individuals with substantial equity who prefer not to liquidate other savings or investments. Lenders set the HELOC credit limit based on available equity, often allowing borrowing up to 80% to 85% of the home’s appraised value, minus any outstanding mortgage balance. This approach allows a homeowner to access liquidity without selling their existing property first.

Mortgage Lender Underwriting Considerations

When a new mortgage lender evaluates an application using a HELOC for the down payment, specific underwriting considerations arise. Lenders scrutinize the borrower’s debt-to-income (DTI) ratio, which measures the percentage of gross monthly income allocated to debt payments. The new HELOC debt, including its monthly payments, will be factored into this ratio, potentially affecting eligibility for the new mortgage. Most lenders typically prefer a DTI ratio of 43% to 50% or lower, indicating a borrower’s capacity to manage additional financial obligations.

Lenders also require verification of the down payment funds’ source. Funds obtained from a HELOC are considered “borrowed funds” secured by an asset, rather than personal savings or a gift. While borrowed funds secured by an asset are generally acceptable, unsecured borrowed funds are typically not permitted for down payments. Borrowers provide bank statements, usually covering the last 60 to 90 days, to document the transfer. Large or unusual deposits require explanation and supporting documentation.

The new mortgage lender will assess the loan-to-value (LTV) ratio on the existing property from which the HELOC was drawn. The HELOC’s outstanding balance, combined with the primary mortgage on that property, contributes to its combined loan-to-value (CLTV). A higher CLTV signifies increased risk for the lender, as it indicates less equity remaining in the collateral. While some lenders allow CLTVs up to 90%, the typical maximum limit is around 80% to 85% of the home’s value.

Key Financial Factors to Consider

Using a HELOC for a down payment introduces a layer of financial complexity, primarily due to the creation of “double debt.” The borrower simultaneously carries a mortgage on the new home and the outstanding HELOC debt on their existing property. This results in managing two separate loan payments, impacting household cash flow and financial flexibility.

Most HELOCs have a variable interest rate, tied to a benchmark like the prime rate. Fluctuations can cause monthly HELOC payments to change, potentially increasing over time and making budgeting challenging. While some HELOCs offer interest-only payments during an initial draw period, this can lead to a significant increase in monthly obligations once the repayment phase begins and principal payments are required.

The property securing the HELOC, typically your primary residence, serves as collateral. Failure to make timely payments can put the existing home at risk of foreclosure. Borrowers should account for closing costs associated with both the HELOC and the new mortgage, which can range from 2% to 6% of the loan amounts. Interest paid on a HELOC may be tax-deductible if funds are used to buy or improve the property securing the loan; consult a tax advisor for specific guidance.