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Getting a home equity line of credit (HELOC) to buy a second home can be risky. Often used for real estate investment projects, HELOCs allow homeowners to tap into their home equity for a line of credit. So, in certain situations, using one to buy a second home or investment property may be beneficial; at other times, it could be risky.
HELOC vs. Home Equity Loan
First, it’s important to know the main differences when deciding between a HELOC or a home equity loan.
A HELOC works similarly to a credit card. You draw money from a set limit a lender allows during a drawing period. During that time, you can also make payments toward interest only. Once the drawing period closes, you begin payments for the remainder of the loan life with a varying interest rate, including the principal.
When getting a home equity loan, the lender will give you a lump sum of money upfront. After you get the money, you’ll pay it off at a fixed rate.
Getting a HELOC For a Second Property
1. Find your Loan-to-Value (LTV) Ratio
The most important part of the HELOC process is finding the loan-to-value (LTV) ratio of the property you plan to borrow against. The LTV is what lenders use to figure out the maximum amount available to you through a HELOC.
The ratio looks at the appraisal value of the house mortgaged and how much equity the homeowner holds in that house. So, a property worth $200,000, with $160,000 remaining on the mortgage, has an LTV of 80%.
Most lenders will offer a HELOC loan on primary residences up to 85% LTV.
|FINDING YOUR HELOC ELIGIBILITY
|Example: Let’s say you own a home worth $375,000 and your mortgage still sits at $262,500. That means you have 70% LTV (30% of the loan is paid off). If a bank offers up to 85% LTV, how would you figure how much you can borrow?
Take the percentage of your mortgage remaining and subtract it from the maximum LTV offered.
85% LTV (Lender max) – 70% LTV (your remaining LTV) = 15%
Take the remaining percentage and multiply that to your existing home value. The amount you’re left with is how much you would be qualified to borrow.
$375,000 (Home Value) x .15 (15% – LTV Difference) = $56,250
Answer: $56,250 total amount allowed to be borrowed.
2. Lay Out Your Budget
Learning the LTV of the property is pivotal to setting up a budget for using a HELOC to buy a second home. You’ll need to review your finances closely because once you use the HELOC for a second home, you will make several more monthly payments.
In addition to your primary mortgage, you’ll have the mortgage for the second home, the monthly HELOC loan payment, and closing costs for the HELOC and second home loan mortgage. Those payments come before the costs of any projects or maintenance on the second house.
» MORE: See today’s refinance rates
Pros and Cons of a HELOC for an Investment Property
|Instant money for a down payment on a second home
|Not good if you don’t have a stable monthly income
|Interest-only payments allowed during drawing period, making payments less monthly
|HELOC rates can vary over the years, meaning monthly costs could jump after drawing period
|HELOC on a primary residence comes with easier eligibility requirements
|If you can’t pay off the HELOC, you could lose your primary house
HELOC Tax Deductions
Sometimes, you may be eligible to deduct the interest paid on a HELOC. You can only deduct interest from the HELOC payment if you used the funds to improve or repair the original property used to get the HELOC.
You can’t deduct all of the interest, however. Depending on your filing status, you can deduct up to $750,000 (if filing jointly) or $375,000 (if filing separately) of interest on combined debt, including any mortgages on your primary residence.
Note: If you use the money as a down payment on an investment property, you won’t be able to write off your interest.
The Bottom Line
A HELOC on your primary home is a way to free up funds to get a down payment for a second home or investment property. Plus, it’s considerably less risky if you’ve built up equity in your home.
But a HELOC also comes with varying or adjustable interest rates, possibly subjecting you to increasing monthly payments. Also, it’s worth noting that taking out a HELOC on your primary residence can lead to foreclosure if you cannot pay it back.