Using a home equity loan to buy a vacation house


According to the the U.S. Travel Association, in 2018, one of 55% of Americans did not take all of their PTO. Are you one of the 55% of Americans in this statistic? If you’ve found a destination that you love and go back to year after year, buying a property can be a great plan. 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.

Key Takeaways

  • Home equity loans borrow against the accrued equity in your primary residence.
  • Home equity loans are paid out in a lump sum.
  • Cash from a home equity loan can be used as a downpayment or an all-cash offer on a vacation home.

How a Home Equity Loan Works

A home equity loan is based on the equity you’ve built in your home. Equity is determined by the current value of your home minus the amount 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 you want to borrow. Typically, you cannot borrow the total amount of the equity available—80% is the standard rule of thumb. 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 also pay interest on the loan and 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 are 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 as a substantial downpayment.

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. Lenders typically want to loan 80-85% or less of your equity. For example, if your home is worth $500,000 and you owe $200,000, you would likely be able to borrow $200,000.

What you do with the cash depends on what you want to buy. If you’re aiming for a small lake house or modest cabin in the woods, $200,000 may be enough to buy the property outright, making your home equity loan function as essentially 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 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 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, property managers for when you’re not occupying the home, and second home insurance is also wise.

Warning

You’re used to paying home owner’s insurance on your primary residence, but insurance on a vacation home may be higher. Since you won’t be occupying the house consistently, there is 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 payments, they 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 when you’re not there. Homeowners’ insurance may also 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 enjoying it, the total weight of responsibility will fall on your shoulders—and 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 look for credit scores in the 660-700 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 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 your monthly budget can handle a mortgage and a home equity loan. Also, consider the extra costs of a vacation property: insurance, property management, renovations, and so on. Your home equity loan could offer you buying power in a highly competitive market.

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