How to Use Your Home Equity to Buy a New Home

Home equity is a significant financial asset for many homeowners, representing the portion of a property’s value owned outright. It is the difference between the current market value of a home and the total amount owed on any outstanding mortgages or other liens. This equity can increase over time as mortgage principal is paid down or as the property’s market value appreciates due to market conditions or home improvements. Understanding how to access and utilize this value is beneficial when considering a new home purchase.

Methods for Accessing Home Equity

Homeowners can access equity in their current residence through several methods, ranging from securing new loans against the property to selling the home directly.

A cash-out refinance involves replacing an existing mortgage with a new, larger one, allowing the homeowner to receive the difference in cash. This method requires at least 20% equity after the refinance. Lenders cap the loan-to-value (LTV) ratio at around 80% for conventional cash-out refinances, meaning the new loan cannot exceed 80% of the home’s appraised value. The funds received can then be used for various purposes, including a down payment on a new property.

A home equity loan (HEL) functions as a second mortgage, providing a lump sum upfront. This loan is secured by the home’s equity and comes with a fixed interest rate and set repayment schedule, offering predictable monthly payments. Lenders may allow borrowing up to 80% to 90% of the home’s equity, depending on creditworthiness. The repayment period for a home equity loan can extend up to 30 years.

A Home Equity Line of Credit (HELOC) offers a revolving line of credit, similar to a credit card, secured by home equity. This option provides flexibility, allowing borrowers to draw funds as needed during a “draw period,” often five to ten years. During the draw period, payments may be interest-only. Principal repayment typically begins during a subsequent repayment period, which can last 10 to 20 years. HELOCs often feature variable interest rates that can fluctuate with market conditions. Lenders permit borrowing up to 80% to 85% of the home’s value, minus the outstanding mortgage balance.

The most direct way to access home equity for a new purchase is by selling the current home. Upon sale, after paying off the existing mortgage and covering closing costs, the remaining proceeds become available. This approach is a common method for funding a new home, as it liquidates equity entirely and provides cash for a down payment or full purchase of another property. This simplifies the financial structure by avoiding additional loans on the existing residence.

Applying for Equity-Based Financing

Securing equity-based financing, such as a cash-out refinance, home equity loan, or HELOC, involves a structured application process. Lenders assess a borrower’s financial standing and the property’s value to determine eligibility and loan terms.

The initial step involves gathering documents. Applicants need to provide proof of identity, such as a government-issued ID, Social Security number, and birthdate. Income verification is a primary requirement, often necessitating recent pay stubs (last 30 days) and W-2 forms (previous two years). Self-employed individuals may need to supply two years of tax returns and current profit and loss statements.

Lenders require documentation related to current financial obligations and assets. This includes statements for existing mortgages, other outstanding debts, bank accounts, and investment accounts. Proof of homeowners insurance is a standard requirement. Lenders pull a credit report to assess creditworthiness and payment history.

The application process proceeds with submitting documents to a chosen lender. Following submission, an appraisal of the property is conducted to determine its market value and verify available equity. Underwriting then occurs, where the lender reviews all provided information, including credit score, debt-to-income (DTI) ratio, and loan-to-value (LTV) limits, to make a lending decision. Lenders typically expect a credit score of 620 or higher and a DTI ratio of 43% to 50% or less. Specific thresholds vary by lender. If approved, the process concludes with signing closing documents and funds disbursement.

Utilizing Equity for Your New Home Purchase

Once home equity is accessed, the funds can be strategically deployed to acquire a new home. Direct application of these funds can significantly influence the terms and feasibility of the new purchase.

A primary use of accessed equity is to provide a substantial down payment on the new property. A larger down payment can reduce the amount financed through a new mortgage, potentially leading to lower monthly payments and more favorable interest rates. This can also make a buyer more competitive in a strong real estate market. For instance, using a HELOC for a down payment can help avoid depleting personal savings or liquidating investments.

Beyond the down payment, equity funds can cover various closing costs associated with the new home purchase. These costs include loan origination fees, appraisal fees, title insurance, and other administrative expenses, typically ranging from 2% to 5% of the loan amount. Covering these costs with equity funds can minimize out-of-pocket expenses at the time of closing.

When a new home is purchased before the current home is sold, a HELOC can function as bridge financing. This allows access to funds for the down payment and closing costs on the new property while awaiting the sale of the existing residence. The HELOC balance is typically repaid from the proceeds of the original home’s sale. This strategy can provide financial flexibility and reduce the pressure to sell the current home quickly.

Financial and Tax Implications

Understanding the financial and tax implications of using home equity to buy a new home is important. These considerations impact both the cost of borrowing and potential tax obligations.

Any loan taken against home equity, whether a cash-out refinance, HEL, or HELOC, creates a new repayment obligation. These loans require regular principal and interest payments, adding to a homeowner’s monthly debt burden. The interest rate on these loans, whether fixed for HELs or variable for HELOCs, directly impacts the total cost of borrowing. Various fees are associated with securing these loans, such as origination fees, appraisal fees, and closing costs, increasing the overall expense.

For homeowners who do not sell their existing property, the home remains collateral for any new equity-based loans. This means the property can be at risk if loan payments are not met. These additional loans also affect the homeowner’s debt-to-income ratio, which lenders consider for future borrowing.

Regarding tax implications, interest paid on home equity debt is deductible under specific IRS rules. For tax years 2018 through 2025, interest on home equity loans and lines of credit is deductible only if the borrowed funds are used to buy, build, or substantially improve the home that secures the loan. The total amount of qualified mortgage debt, including any home equity debt used for home acquisition or improvement, on which interest can be deducted is limited to $750,000, or $375,000 for married individuals filing separately. If the funds are used for personal expenses, such as paying off credit card debt or student loans, the interest is not deductible.

When selling a primary residence, homeowners may qualify for a capital gains tax exclusion on any profit realized from the sale. Under IRS Section 121, single filers can exclude up to $250,000 of capital gain, while married couples filing jointly can exclude up to $500,000. To qualify for this exclusion, the homeowner must have owned and used the property as their main home for at least two of the five years leading up to the sale. This exclusion can be claimed once every two years. Any gain exceeding these limits may be subject to capital gains tax, impacting the net equity available from the sale.