Owning a home free and clear suggests to lenders that you know how to manage your money. The property itself actually strengthens some aspects of your mortgage application, but the fact that you already own a home could cause problems for you in other ways.
When you apply for a mortgage, you must prove to your lender that you have enough cash in the bank to cover the closing costs and escrow, which includes taxes and insurance. Beyond that, lenders also like to examine your overall financial picture and gather information on your assets. Existing real estate, as well as vehicles, retirement accounts and life insurance policies, all count toward your overall net worth. Lenders compare these assets with your existing liabilities such as credit cards and other debts. If you have a positive net worth courtesy of your current home, you are much more likely to get a loan than if you have a negative net worth. Simply put, if push comes to shove you can always sell your home to cover your debts and still have some money to play with.
Even the most cautious investors occasionally run into financial problems as the result of a job loss, accident or unexpected medical costs. In a crunch, lenders assume that vacation or investment property mortgages are likely to fall down your list of priorities. To mitigate the risk involved in financing such properties, lenders charge higher rates of interest on these property types. Assuming you live in the home you currently own, your lender will hike up the interest rate you have to pay on the new property. You can get around this by filling out a homestead declaration and choosing the new home as your primary residence -- but only if you intend to actually use it as such.
If you cannot come up with a 20 percent down payment on your home, you can still finance it if you agree to buy private mortgage insurance. PMI covers your lender's losses if you default on your home loan. Insurance firms do not typically offer PMI on investment properties or vacation homes. This means you need to make a down payment of at least 20 percent to buy the new house. The fact you owe nothing on your current home has no impact on PMI since you could conceivably cash out your equity in your existing home at any time.
If you plan to use your existing home as your primary residence then you can use it to your advantage by taking out a cash-out refinance loan on it rather than purchase a mortgage on the new home. You would pay a lower rate than on an investment loan because the lien holder gets to seize your actual home if you renege on the debt. Aside from paying a lower rate, you can also take out a PMI policy if needed and extract over 80 percent of the equity you have in your house. On the downside, you stand to lose your nest if you plans go awry and you find yourself unable to manage the loan.
- Hemera Technologies/Photos.com/Getty Images