If your client is looking to finance a second home, they are in good company. According to data from the National Association of Realtors, 72% of vacation homes are bought with a mortgage. One alternative to a traditional mortgage that some borrowers consider is a home equity loan or home equity line of credit (HELOC).
But is tapping into home equity to finance a vacation home or an investment property a good idea?
Find out how the second home will be used
One factor to consider is the purpose of the second home. This can inform whether or not using a home equity loan is a good idea.
If your client is purchasing a vacation home, then home equity may seem like a natural and logical option, as they are using the equity they’ve built up in one personal residence to purchase another.
On the other hand, if the intent is to buy a rental property or to flip a home, then putting their own home at risk for a business venture requires careful consideration.
What clients need to consider
To help your client decide if using home equity to finance a second property makes sense in their situation, review the following factors with them.
Financial risks. Tapping into home equity comes with many risks. The borrower is taking on a new obligation, which affects their overall financial picture. They need to be aware of the risks involved should they encounter difficulty managing their payments or suffer an emergency or loss of income. Additionally, having a second lien on a primary residence can complicate the selling process when they need to sell their home.
Affordability. To start, your client will want to make sure they have enough equity in their primary residence to use toward a downpayment. While a house tends to require a 20% downpayment, the amount tends to jump to 25% for a second home you don’t plan to live in.
Many buyers overestimate their ability to handle the payment on a home equity loan or HELOC. If the second home is an investment property, your client should make sure they can manage the payment even if the home is not rented out, or in the case of a flip, if it does not sell immediately. And if they are considering a HELOC, which typically has an adjustable rate, they’ll need to be prepared for higher payments should rates adjust. Furthermore, clients must consider the closing costs associated with home equity loans and HELOCs.
Primary residence is on the line. One of the most significant drawbacks of tapping into home equity is that it puts a borrower’s home at risk. Regardless of the purpose of the loan, if they are unable to keep up with the payments, their home can become subject to foreclosure. This is a significant risk to take.
Tax implications. Borrowers should be aware of the tax consequences of using home equity. According to recent tax laws, the interest paid on a home equity loan is tax-deductible only if the money is used on the property secured by the loan. This means that if a borrower takes out a home equity loan to purchase a second property, the interest is not tax-deductible. Borrowers may want to consider tax-friendly alternatives.
Alternatives to suggest
Using home equity is just one approach to financing a second property. Here are other options to review with your clients.
Cash-out refinance. Some borrowers may be better off pursuing a cash-out refinance. This option is similar to a home equity loan or HELOC in that it also accesses home equity, will require a similar approval process and is subject to a lender’s maximum loan-to-value ratio. However, unlike a home equity loan or HELOC used to purchase another property, the interest paid on a mortgage is tax-deductible up to limits established by the IRS.
401k loan. Borrowers may also consider borrowing against their 401k balance. This approach, of course, comes with many implications to consider, such as tax consequences, early withdrawal penalties and the fact that the loan will become due within a specific window should your client resign or lose their job. In addition, unplugging retirement funds is generally not advised because of lost opportunity costs.
Roth IRA. Your client can access the money they’ve contributed to a Roth IRA without any penalties — as with a 401k, though, they’ll need to consider the lost opportunity costs.
Delay the purchase. Not the most popular option, but holding off on buying a second home and saving up the down payment may be the best course of action. For most borrowers, this approach provides the least amount of risk.
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