According to the US Travel Association, in 2018, one in 55% Americans did not take their entire PTO. Are you one of the 55% of Americans in this statistic? If you’ve found a destination you love and return there year after year, buying a property can be a great plan. But how are you going to pay for it? While saving for your vacation home is the most financially responsible thing, it’s not the fastest. 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 come true.
Key points to remember
- Home equity loans borrow against the accumulated equity in your principal residence.
- Home equity loans are paid out in a lump sum.
- Money from a home equity loan can be used as a down payment or as a cash offer on a vacation home.
How a home equity loan works
A home equity loan is based on the equity you have built in your home. Equity is determined by the current value of your home minus the amount you owe on your mortgage. Your net worth can fluctuate since home values depend on market conditions, such as available inventory and developments in the area.
A home equity loan uses this equity as collateral for the amount you want to borrow. Generally, you cannot borrow the full amount of equity available – 80% is the standard rule of thumb. Home equity loans are considered as secured loans because they come with physical collateral and come with attractive interest rates.
The process of getting a home equity loan is similar to applying for a first mortgage. The value of the home should be established through an appraisal and then the terms are decided. Home equity loans are paid in a lump sum in cash and must be repaid over time on a fixed payment schedule.
In addition to the amount you borrow, you will also pay interest on the loan and closing costs which cover loan preparation, origination fees and registration fees. Some lenders offer the option of paying points or prepaid interest at closing. This may reduce your overall refund 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 can use the money from a home equity loan to buy your vacation home: as an all-cash purchase or as a substantial down payment.
Most home equity loans only allow you to borrow a percentage of your total equity. Even if your home is fully paid off, you won’t necessarily have access to its full market value. Lenders generally want to lend 80-85% or less of your capital. For example, if your house is worth $500,000 and you owe $200,000, you could probably borrow $200,000.
What you do with the money depends on what you want to buy. If you’re aiming for a tiny lakeside home or a modest cabin in the woods, $200,000 may be enough to buy the property, making your home equity loan essentially function as a mortgage for your vacation home. If you’re considering buying a property outside of the United States, a cash offer can make the purchase easier and allow you to forgo working with a lender for the rest of the purchase price.
If you’re aiming for a beach house or a mountain retreat, you may need to use your lump sum as a large down payment on your property. This may provide you with better rates and terms for the required mortgage. It’s also a good idea to have a little extra cash to cover repairs, property managers when you’re not occupying the house, and second home insurance.
You are used to paying for home insurance on your primary residence, but the insurance on a vacation home may be higher. Since you won’t be constantly occupying the house, there’s a higher risk of something happening while you’re away, such as flooding or break-ins. Talk to your insurance company for additional considerations.
Advantages and disadvantages
Whether you’re paying cash or using your home loan as a down payment for a vacation home, there are risks to using the equity in your home. Since home equity loans are a second mortgage, you will need to factor an additional payment into your monthly budget. Since you are using your primary residence as collateral, your lender will place a second lien on your home. If you don’t make your payments, they can potentially take your house.
When calculating your monthly budget with your home equity loan, consider the additional costs of a second home. You may need to hire a property manager to watch the house when you are away. Home insurance may also be higher. Buy near the beach or the lake? Flood or hurricane insurance may be required. If you don’t plan to rent out your property when you’re not enjoying it, the full weight of the responsibility will fall on your shoulders and on your budget.
In the plus column, a home equity loan usually has very reasonable rates and a fixed repayment schedule. A home equity loan may be easier to obtain than a new mortgage for your second property.
What credit rating do you need for a home equity loan?
Lenders look for credit scores between 660 and 700 at a minimum. Since credit scores are based on timely payments and credit usage, a score in this range indicates 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 debts before deciding how much credit to extend. Your CLTV must be at least 80% of the home’s appraised value.
Can I use a home equity loan for upgrades to my vacation home?
Yes. Since home equity loans are repaid in a lump sum, you can use them for any purpose, including renovating a vacation home you purchased using other financing.
A home equity loan is one of the most flexible forms of financing if you already own. Buying a holiday home is an important decision and not without risks. Before buying a vacation home, make sure your monthly budget can support a mortgage and home equity loan. Also consider the additional costs of a vacation property: insurance, property management, renovations, etc. Your home equity loan could provide you with buying power in a highly competitive market.