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If you’ve found a destination that you love and return to year after year, buying a property there can be a good investment. But how will you pay for it? While saving for your vacation home is the most fiscally responsible thing, it’s not the most expedient. If you’re ready to buy now and own a primary residence, a home equity loan can be a great way to make your dreams a reality. Using the equity in your home as collateral, this type of loan to either cover a down payment on vacation home or make an all-cash purchase outright, depending on where you want to buy and how much equity you have.
Key Takeaways
- Home equity loans borrow against the accrued equity in your primary residence, which equals the value of your home minus your mortgage balance.
- Funds from a home equity loan can be used as either a down payment or an all-cash offer on a vacation home.
- In addition to needing to repay the amount taken out, you’ll also have to account for interest, closing costs, fees, insurance, property management costs, renovation and repair costs, etc.
How a Home Equity Loan Works
A home equity loan is based on the equity that you’ve built in your home. Equity is determined by the current value of your home minus the amount that you owe on your mortgage. Your equity can ebb and flow since home values depend on market conditions, such as available stock and developments in the area.
A home equity loan uses that equity as collateral for the amount that you want to borrow. Typically, you cannot borrow the total amount of the equity available. Home equity loans are considered secured loans since they have physical collateral attached and come with attractive interest rates.
The process of obtaining a home equity loan is similar to that of applying for a first mortgage. The home’s value has to be established through an appraisal, then terms are decided. Home equity loans are paid in a lump sum of cash and have to be repaid over time on a fixed payment schedule.
In addition to the amount you borrow, you’ll pay interest on the loan, closing costs that cover the preparation of the loan, origination fees, and recording fees. Some lenders offer the option of paying points, or prepaid interest, at closing. This can lower your overall repayment amount but will increase your closing costs. You can choose how many points to take, if any, with your lender.
How to Buy a Vacation Home With a Home Equity Loan
The beauty of home equity loans is their flexibility. Since they’re paid in a lump sum and repaid over time, they can be used for any purpose—including buying a vacation home. You could use the cash from a home equity loan to purchase your vacation home: as an all-cash purchase or a substantial down payment.
Most home equity loans will only allow you to borrow a percentage of your total equity. Even if your home is completely paid off, you won’t necessarily have access to its full market value. The amount that a lender might offer will be based (at least partially) on the combined loan-to-value (CLTV) ratio of 80% to 90% the home’s appraised value.
For example, suppose your home is worth $500,000 and you owe $200,000. To find the maximum CLTV ratio, multiply the value of your home ($500,000) by 90% (0.9), then subtract your current debt balance ($200,000). The remainder ($250,000), is the maximum amount you’d likely be able to borrow with a home equity loan.
What you do with the cash depends on what you want to buy. If you’re aiming for a small lake house or a modest cabin in the woods, $250,000 may be enough to buy the property outright, essentially making your home equity loan function as a mortgage for your vacation home. If you’re contemplating buying property outside of the United States, an all-cash offer may make it easier for you to buy a property and allow you to forgo working with a lender for the rest of the purchase price.
If you’re aiming for a beach home or a mountain retreat, you may need to use your lump sum as a hefty down payment on your property. Doing so may afford you better rates and conditions for the required mortgage. Having a bit of extra money to cover any repairs and renovations, property managers for when you’re not occupying the home, and second home insurance is also wise.
You may be used to paying homeowners insurance on your primary residence, but insurance on a vacation home might be higher than you’d expect. Since you won’t be occupying the house consistently, there’s a higher risk that something may happen while you’re gone, such as flooding or break-ins. Talk to your insurance company for additional considerations.
Pros and Cons
Whether you pay all cash or use your home equity loan as a down payment for a vacation home, there are risks to using your home’s equity. Since home equity loans are a second mortgage, you’ll have to factor an extra payment into your monthly budget. Since you’re using your primary residence as collateral, your lender will place a second lien on your home. If you fail to make your loan payments, then your lender can potentially take your house.
When you’re figuring your monthly budget with your home equity loan, consider the extra costs of a second home. You may have to hire a property manager to watch over the house while you’re not there. Homeowners insurance also may be higher. Buying near the beach or lake? Flood or hurricane insurance may be in order. If you’re not planning on renting out your property when you’re not using it, then the total weight of responsibility will fall on your shoulders—and on your budget.
In the plus column, a home equity loan typically has very reasonable rates and a fixed repayment schedule. A home equity loan may be easier to qualify for than a new mortgage for your second property.
What Credit Score Do You Need for a Home Equity Loan?
Lenders generally look for credit scores in the mid-600s to 700+ range as a minimum. Since credit scores are based on timely payments and credit utilization, a score in this range shows responsible money management.
How Do Lenders Determine How Much I Can Borrow on a Home Equity Loan?
Lenders base your loan eligibility on your combined loan-to-value (CLTV) ratio and your debt-to-income (DTI) ratio. This means that lenders look at all your debt before deciding how much credit to extend. Your CLTV should be at least 80% of the home’s appraised value.
Can I Use a Home Equity Loan for Updates on My Vacation Home?
Yes. Since home equity loans pay out in a lump sum, you can use them for any purpose, including renovating a vacation home that you purchased using other financing.
The Bottom Line
A home equity loan is one of the most flexible forms of financing if you’re already a homeowner. Buying a vacation home is a big decision and not without risks. Before purchasing a vacation home, make sure that your monthly budget can handle a mortgage and a home equity loan. Additionally, consider the extra costs of a vacation property: insurance, property management, repairs and renovations, and so on. Your home equity loan could offer you buying power in a highly competitive market.