Coming up with money for a down payment on a new home is often the biggest struggles would-be homeowners face. However, if you already have a home, you can leverage some of the equity you have built up to acquire another house. You often pay less when you secure a second lien to your existing home, rather than taking out an actual purchase mortgage on the new home. However, there are also potential downsides to cashing out your home equity.
Interest rates on primary residences are usually lower than on investment homes, because lenders work on the premise that you are less likely to default on loans tied to your primary home. You can tap into your existing home equity by taking out a cash-out refinance loan. When you do this, you extract enough cash to pay off your existing mortgage and get the cash you need to buy the new home. With a cash-out refinance, your total loan amount typically cannot exceed 80 percent of your home's value. Alternatively, you can leave your existing mortgage in place and take out a second loan in the form of an equity loan or line of credit.
Depending on your overall financial circumstances, you can potentially claim tax deductions for interest payments on a refinance loan tied to your primary residence. You can also potentially write off interest payments on a second lien equity loan or line of credit. Equity lines work similarly to credit cards, because you have access to a revolving credit line, and you have the option of making interest only payments for a certain number of years. In theory, you could deduct your entire monthly payment from your taxable income if you do not make any principal payments.
Closing costs for home equity loans and lines are usually much lower than on first mortgages because you do not have to pay for title insurance and some of the other closing costs that are associated with first mortgages. You would have to buy title insurance and cover these other costs if you bought your new property with a purchase mortgage. Additionally, if you take out an equity line you can draw on the line as and when you need to. If you take out a cash-out refinance or purchase loan, you have to start paying interest from the day the loan closes.
When you use your existing equity to finance a second home you stand to lose your primary home if you fall behind on the loan payments. Equity lines of credit usually have variable interest rates, which mean your payments could skyrocket over the course of time. Home equity loans tend to have shorter terms than regular mortgages, which means larger monthly payments to manage. If your payments fall well within your budget, then a cash-out refinance or equity line may make sense, but if funds are tight, then the cons may outweigh the pros.
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