You can use the equity in your current home to buy another house, and most buyers do it one of three ways: a home equity line of credit (HELOC), a home equity loan, or a cash-out refinance. Each one converts part of your home’s value into cash you can put toward a down payment or, if you have enough equity, the full purchase price of the second property. The catch is the one that governs every decision that follows: your primary residence is the collateral, so a problem with the new loan can cost you the house you already own.
Your equity is the gap between what your home is worth and what you still owe. A home appraised at $500,000 with a $300,000 mortgage balance holds $200,000 in equity. Lenders will let you borrow against a portion of that, but not all of it, and the exact portion depends on which product you choose and what you plan to buy.
The Three Ways to Pull Equity Out
HELOC
A HELOC is a revolving credit line secured by your home, usable during a draw period that typically runs ten years. The lender takes a subordinate lien, so your original mortgage keeps first-priority repayment status.1Fannie Mae. First Lien Delivered with Subordinate Financing The rate is variable, so the monthly payment can move. A HELOC fits well if you’re not certain exactly when or how much you’ll need.
Home Equity Loan
A home equity loan hands you a single lump sum at a fixed rate, repaid in equal installments. It also sits in second position behind your first mortgage.1Fannie Mae. First Lien Delivered with Subordinate Financing The fixed payment makes budgeting predictable, which helps when you know the down payment figure you’re writing a check for.
Cash-Out Refinance
A cash-out refinance replaces your current mortgage with a new, larger one and you take the difference in cash. There’s no second mortgage, just one first-priority lien at a new rate and term covering the full balance. That reset can work in your favor if current rates beat your existing rate, and against you if they don’t. Closing costs tend to run higher than on a standalone equity loan because you’re refinancing the whole mortgage, not just the amount you’re pulling out.
What Lenders Require
Four benchmarks drive approval when the borrowed funds are going toward a second property.
- Combined loan-to-value ratio. Your total mortgage debt against the home you’re borrowing from, including the new loan, has to stay under a cap set by the loan type and the second property’s use. For a second-home purchase, Fannie Mae allows up to 90 percent CLTV on a one-unit property; for an investment property, the cap drops to 85 percent on one unit and 75 percent on two-to-four units.2Fannie Mae. Eligibility Matrix
- Credit score. Fannie Mae’s floor for conventional loans is 620, and a score of 700 or higher typically earns a better rate.3Fannie Mae. General Requirements for Credit Scores
- Debt-to-income ratio. Fannie Mae’s automated underwriting system allows DTI up to 50 percent; manually underwritten loans cap at 45 percent with compensating factors. The projected payment on the new borrowing counts toward the ratio.4Fannie Mae. Debt-to-Income Ratios
- Cash reserves after closing. Fannie Mae requires at least two months of reserves for a second-home purchase and six months for an investment property. If you already own other financed properties beyond the one you’re borrowing against, you need additional reserves equal to 2 percent of the combined unpaid balance on those mortgages, rising to 4 percent for five or six financed properties and 6 percent for seven to ten.5Fannie Mae. Minimum Reserve Requirements
Second Home or Investment Property
How you’ll use the second house changes the rules. A second home is one you intend to occupy for part of the year; an investment property is one bought mainly to generate rental income. Investment properties face stricter terms across the board: larger down payments, more reserves, and often a higher rate. The CLTV cap drops from 90 percent to 85 percent on a one-unit purchase,2Fannie Mae. Eligibility Matrix and reserve requirements run three times higher.5Fannie Mae. Minimum Reserve Requirements
Don’t try to work around the stricter investment rules by telling the lender a rental property will be your vacation home. Misrepresenting intended use on a mortgage application is occupancy fraud, and federal law allows fines up to $1,000,000 and up to 30 years in prison for false statements on a mortgage application.6Office of the Law Revision Counsel. 18 U.S. Code 1014 – Loan and Credit Applications Generally Criminal prosecution of individual borrowers is uncommon in practice, but a lender who discovers the misrepresentation can call the full loan balance due immediately. Not paying it leads to foreclosure.
The Tax Trap on Equity Used to Buy a Separate Property
Interest on a home equity loan or HELOC is deductible only when the borrowed funds are used to buy, build, or substantially improve the home that secures the loan.7IRS. Publication 936 – Home Mortgage Interest Deduction That rule bites hard here. If you pull a HELOC on your primary residence and spend the money on a different house, the HELOC interest is generally not deductible, because the money didn’t go into the home that secures it. A cash-out refinance works the same way: interest on the cash-out portion spent on a separate property doesn’t qualify as deductible mortgage interest on your primary home.
Interest on a new purchase mortgage taken out directly on the second property can qualify as deductible acquisition indebtedness. For loans taken out after December 15, 2017, the combined mortgage debt on your primary and second home has to stay at or below $750,000, or $375,000 if married filing separately.8Office of the Law Revision Counsel. 26 U.S. Code 163 – Interest Debt from before that date follows the older $1,000,000 limit.7IRS. Publication 936 – Home Mortgage Interest Deduction A second home used exclusively as a rental isn’t a qualified residence at all; it’s an investment property, and rental property interest follows its own rules.
The Risks Worth Taking Seriously
Your Primary Home Can Be Foreclosed On
A HELOC or home equity loan puts a second lien on the house you live in. Default on that loan and the second-lien holder has the right to foreclose. The first mortgage lender gets paid first out of any sale proceeds, but the forced sale still happens. A relatively small equity-loan default can cost you the whole house.
Being Overleveraged When Values Fall
If prices drop, you can owe more than the home is worth. Carrying a first mortgage plus an equity loan on your current house while also holding a second property amplifies that exposure. A decline in the second property’s value compounds the problem and shrinks your options to sell your way out.
Cross-Collateralization Clauses
Some loan agreements let the same collateral secure more than one loan. If the clause is in your agreement, you may not be able to sell or refinance your primary home until every loan tied to it is paid off, including loans you thought were independent. Read the agreement and ask the lender directly whether a cross-collateralization clause applies.
Variable-Rate Exposure on a HELOC
HELOC rates move. If you’re already stretched across two properties, a rate increase can push your DTI past what you can comfortably carry. A fixed-rate home equity loan removes that specific risk but locks the rate in if the market later drops.
Closing Costs
Equity borrowing isn’t free. HELOCs and home equity loans typically run 2 to 5 percent of the loan amount in closing costs, covering the appraisal, title search, and origination fees. Some lenders waive closing costs, especially on smaller amounts, so it pays to compare offers. A cash-out refinance generally costs more to close because you’re refinancing the entire mortgage balance rather than just the amount you’re taking out. Build those costs into the comparison before deciding whether equity is really the cheapest way to fund the second purchase.