How to Use Equity to Buy Another House

Home equity, the portion of your property you own outright, is a significant financial asset. Leveraging this value allows homeowners to access funds for new real estate opportunities. This article explores how existing home equity can finance the purchase of another residence, detailing the mechanisms for accessing these funds and their subsequent application.

Understanding Home Equity and Its Value

Home equity signifies the ownership stake a homeowner has in their property. It is calculated by subtracting the outstanding mortgage balance and any other liens from the home’s current market value. For instance, if a home is valued at $400,000 with a $150,000 mortgage balance, the equity is $250,000. This amount grows as mortgage principal is paid down and as the property’s market value appreciates.

This accumulated equity is a valuable financial resource. Lenders require a minimum of 15% to 20% equity before allowing homeowners to borrow against it.

Methods for Accessing Home Equity

Homeowners have several primary methods for accessing the equity built up in their property, each with distinct structures and requirements. These include a cash-out refinance, a home equity line of credit (HELOC), and a home equity loan. Each option provides a different approach to converting equity into usable funds.

Cash-Out Refinance

A cash-out refinance replaces an existing mortgage with a new, larger mortgage that includes a cash distribution. The new loan pays off the original mortgage, providing the difference as a lump sum. Eligibility requires a credit score of at least 620. Lenders look for a loan-to-value (LTV) ratio of 80% or less, meaning the new mortgage cannot exceed 80% of the home’s value, and a debt-to-income (DTI) ratio no greater than 43%. The new loan carries a fixed interest rate and a repayment term, often 15 to 30 years.

Home Equity Line of Credit (HELOC)

A Home Equity Line of Credit (HELOC) functions as a revolving credit line, allowing homeowners to borrow money as needed up to a predetermined limit. During an initial “draw period” (5 to 10 years), borrowers access funds, often making interest-only payments. A “repayment period” (10 to 20 years) then begins, requiring principal and interest payments. HELOCs have variable interest rates, so payments can fluctuate. To qualify, lenders require a credit score of at least 620, a DTI ratio below 50%, and at least 15% to 20% equity, with a combined loan-to-value (CLTV) ratio capped around 80% to 85%.

Home Equity Loan

A home equity loan, also known as a second mortgage, provides a lump sum repaid over a fixed term with regular, fixed monthly payments. This structure offers predictability, as both the interest rate and payment amount remain consistent. Repayment terms range from 5 to 20 years, though some extend up to 30 years. Qualification criteria are similar to HELOCs, requiring a credit score of at least 620 and a DTI ratio below 43% to 50%. Lenders require homeowners to have at least 15% to 20% equity in their home.

Applying Accessed Equity to a New Home Purchase

Once home equity funds are accessed through a cash-out refinance, HELOC, or home equity loan, they can be applied towards a new property. These funds primarily serve as a source for the down payment and to cover closing costs. Utilizing these funds can reduce the need for liquid savings, preserving them for other purposes.

Using Cash-Out Refinance Funds

For those who opt for a cash-out refinance, the lump sum can directly fund a significant portion or the entirety of the down payment on the new property. This method merges the original mortgage with the new cash-out amount into a single loan, simplifying the payment structure for the existing home. The funds can also cover various closing costs on the new purchase, such as loan origination fees, appraisal fees, title insurance, and escrow charges, which range from 2% to 5% of the new loan amount. This approach can be beneficial if the new mortgage carries a lower interest rate than the previous one.

Using HELOC or Home Equity Loan Funds

Using a HELOC or home equity loan involves two separate loans on the existing property. Funds drawn from a HELOC or received as a lump sum from a home equity loan can then be used for the down payment and closing costs on the new home. A HELOC offers flexibility, allowing for draws as needed, useful if the new home purchase timeline is uncertain or if renovations are planned. A home equity loan, providing a single disbursement, is suitable when the exact amount needed for the new home’s down payment and closing costs is known upfront.

Timing Considerations

The timing of these transactions is a significant consideration. When the sale of the current home is contingent on a new purchase, or vice versa, accessed equity can provide necessary liquidity. Some homeowners use these funds as a “bridge” to purchase the new home before their current property is sold, allowing for a smoother transition. This strategy requires careful financial planning to manage payments on both properties until the first home is sold.

Important Financial Considerations

Undertaking a new home purchase by leveraging existing home equity requires careful financial planning. The decision impacts a homeowner’s overall financial health and future obligations. It is important to evaluate how this strategy affects various financial ratios and responsibilities.

Debt-to-Income (DTI) Ratio

One consideration is the debt-to-income (DTI) ratio, which measures monthly debt payments against gross monthly income. With a new mortgage and potentially an existing home equity loan or HELOC payment, the DTI ratio can increase substantially. Lenders prefer a DTI ratio no higher than 43% to 50%; exceeding this can impact future borrowing capacity or the ability to secure favorable terms. Managing multiple mortgage-related payments requires a stable income and diligent budgeting.

Cost of Borrowing

Understanding the full cost of borrowing across all loans is important. This includes interest rates on the new mortgage and the equity access vehicle, plus associated fees like closing costs, appraisal fees, or origination fees. While home equity products offer competitive rates, comparing the annual percentage rate (APR) across all financing components provides a complete picture of the total borrowing expense. Analyzing these costs helps ensure the financial viability of the new home purchase.

Emergency Fund

Maintaining a strong financial position, including an emergency fund, is relevant when taking on additional debt. Increased monthly obligations from multiple property loans can strain finances if unexpected expenses arise or income fluctuates. An adequate emergency fund, covering three to six months of living expenses, provides a buffer against unforeseen circumstances. Consulting with financial advisors or mortgage professionals can offer tailored guidance, helping to assess feasibility and optimize the financial structure for acquiring another property.