You probably know about home equity if you’re a homeowner. Home equity refers to the market value of your unencumbered interest in a property. In other words, it’s the difference between your home’s market value and the outstanding balance of any financial claim a person or entity holds against that property, such as a mortgage.
You also might know about home equity loans. A home equity loan is a kind of consumer loan where you take out a second mortgage by borrowing against your home’s equity.
You might look at a home equity loan for debt consolidation, but you can also use the money from a home equity loan to purchase another property. We’ll talk about some incentives and drawbacks if you choose to do that in the following article.
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Using Home Equity to Buy a Second Property
Let’s say you own a home but don’t own it outright. You have a substantial amount of equity in it because you’ve been making mortgage payments for years. If so, you’re probably eligible for a home equity loan if you get a favorable rate and ample time to pay that money back from a lending entity like a bank or credit union.
You might take that chunk of money and use it as a down payment on a second home. You could use that second property as a rental or allow a relative to live there. If you’re a parent, for instance, and you have an adult child, you can let them live in that home if you feel generous.
In this scenario, you can use the second property to generate passive income if you rent it out. You can use the money from it to pay the principal and the interest on the home equity loan you took out on the first property.
If you do this, you can eventually own the second property outright. Alternatively, if you let a relative live there, they can pay you money that you can use to pay off the principal and interest, and eventually, they can own that second property free and clear.
That’s an appealing setup if you have a relative such as an adult child who’s starting a family and wants a place of their own. That property can be your gift to them.
The main drawback of using the equity in one property to purchase another is that you risk losing both homes if you can’t pay back the principal and the interest from the home equity loan you took out. If you default on that loan, you might forfeit both properties to the bank or credit union from which you borrowed the money.
To guard against this, you need to install someone in the second home you know can pay you rent regularly. Whether you’re letting someone you don’t know or a relative stay there, you should feel confident they have gainful employment. That way, they can give you money every month, allowing you to keep up with the payments to the lending entity that granted you the home equity loan.
Should You Use this Strategy?
Using the equity from one home to buy a second one can work for some people, but it’s not for everyone. The main advantage if you choose to do this is that you can potentially generate passive income.
You might let a family member stay in that second property if they can pay you rent. Eventually, you can consider giving it to them as a gift once it has been paid off entirely. You can also keep using it as a rental property for tenants if you don’t mind acting as a landlord.
The main drawback is that you can lose both properties if you default on the home equity loan. To avoid this, you’ll need to only install someone in that second property who has a good job they’re not likely to lose. You should consider carefully before deciding whether to take this action.