Is it a Good Idea to Put My Equity Into a Second Home?

Whether you want to buy a second home for personal use or as a rental, using your home equity to buy a second home may prove to be the way to do it. If you have sufficient equity in your house or own it outright, taking out a home equity loan for a down payment on a new home is a good option. However, if you don’t have much equity in your current home, or if local real estate prices are dropping, taking equity out of your home to buy another house is a risky move. Recent changes in the tax law may also affect your decision.

Many people want to buy a vacation home with the idea that they’ll also earn money by renting it out when they aren’t using it. However, if you use a vacation home in this manner, it becomes a de facto rental property as far as a mortgage lender is concerned. Keep that in mind if you need a mortgage because the equity in your primary home isn’t sufficient to completely finance the second home purchase. If you do plan to rent out a vacation home, expect to provide the lender with an appraisal of a similar home and its rental schedule. The lender needs to know the vacation/rental home’s potential income. Expect to pay a somewhat higher mortgage rate for a rental property and to put down at least 20 percent. There’s rarely private mortgage insurance eligibility with a rental home. A home equity loan comes in handy for the down payment.

Keep in mind that if you rent out your vacation home for more than 14 days out of the year, you must report the rental income on your income tax return. That holds true even if you conduct a one-time-only rental exceeding the 14-day limit.

Using equity in one property to buy another is a common way to make a second home purchase. Perhaps you’ve paid off the mortgage on your primary residence, and it’s worth $500,000. You can tap the equity in your home and purchase a vacation home for $250,000. If you go that route, you’ll own the second home outright but now have a home equity loan, which is akin to a second mortgage, on your primary dwelling. Because home equity loans are secured by the collateral in your main home, their rates are relatively low. Closing costs for a home equity loan are also lower than such settlement costs for conventional mortgages. In fact, your lender may cover many if not all of the closing costs for a home equity loan.

Of course, you may still have a mortgage on your main property but sufficient equity to either pay for a second home in full or put down a significant down payment. The higher your down payment, the better interest rate you should receive on your second home mortgage.

The Tax Cuts and Jobs Act, signed into law by President Trump on December 22, 2017, enacted significant changes regarding mortgage interest and property tax deductibility. While there are now limitations on the deductibility of home equity loans and home equity lines of credit, or HELOC, you can still deduct mortgage interest if the funds were used to buy, build or substantially improve a home.

However, that does not include interest on a home equity loan taken out to purchase a vacation home, according to the IRS. If the taxpayer took out a conventional mortgage loan to purchase the vacation home, that amount is deductible as long as the total amount of mortgages between the primary home and the vacation home do not exceed $750,000. Prior to the TCJA, the deductible mortgage limit was $1 million. The TCJA also limits total property tax deductions to $10,000 annually, which means those living in areas with high property taxes may not be able to deduct the full amount. For example, if the property taxes on your primary home are $8,000 annually, and your vacation home property taxes are $3,000 a year, that’s $1,000 that you can no longer deduct from your income taxes.

The TCJA changed some of the dynamics involving using home equity to buy a second house. If you were counting on deducting your home equity loan interest as well as the property taxes on your new home, you’ll have to calculate whether giving up the home equity loan deduction and possibly the property tax deductions makes economic sense for you. While there’s not much you can do about the property tax aspect if your two homes exceed the $10,000 limit, you may want to consider obtaining a mortgage on your second home rather than using home equity.

You must also consider what happens if the economy declines precipitously as it did during the Great Recession. While it’s great to own your second home outright by tapping your main home’s equity, what happens if real estate prices plunge and the home equity loan you took out on your primary home now makes you underwater? That’s the term for when mortgages exceed the value of the property.

What would you rather have: a fully paid vacation home or complete ownership/ substantial equity in your main house if the economy heads south? If that’s a concern, you may want to just use home equity to make the down payment on a second home rather than buying the home outright. Perhaps it would make more sense to put a large down payment on the second home using home equity of, say, $50,000 or 20 percent on a $250,000 vacation home rather than risking more of your primary home. Yes, you’d have to take out a regular mortgage, but you can still deduct the interest as long as all of your mortgages don’t exceed $750,000. In a worst-case scenario, walking away from any mortgage and losing your home to foreclosure is a difficult situation that can affect your credit rating for years. For practical purposes, though, walking away from a second home mortgage will not affect your life as much as losing the primary home. There’s an exception if both houses are of similar value, and you intended for your second home to become your full-time home in retirement.

There are other ways to finance your down payment on a second home besides a home equity loan or HELOC. However, these also have their pitfalls. If you take money out of your retirement funds, you’ll pay a penalty if you’re under age 59 ½, and you’ll have less money to live on once you do retire. If you have nonretirement investment funds, that’s a possible option for second-home financing, but make sure you don’t use your entire nest egg to buy another house. Real estate is often a good investment, but it’s not liquid. If you do have an emergency, you could end up in financial trouble if you’ve spent too much of your savings on a second home.