Using cash-out refinancing to buy a second home: a good idea?
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Many people want a second location to use as a dream retirement home, vacation home, or investment property. Using a cash refinance can help you pay the down payment on a second home – and you may also be able to lower the interest rate on your existing mortgage.
Here’s what you need to know about using withdrawal refinance to buy another home:
How to buy a second home with cash-out refinancing
Withdrawal refinancing allows you to access the equity in your home by replacing your first mortgage with a larger mortgage. You will pay off your new mortgage and receive the difference in cash. A popular strategy among homeowners is to use this lump sum to finance the down payment for a second home.
Typically, you can withdraw up to 80% of the equity in your home minus the current loan balance. The only exception is a VA cash-out refinance loan. These loans allow you to refinance up to 100% of the value of your home, but they have stricter eligibility standards.
Keep in mind that the lender will also deduct the closing costs from the withdrawal amount. Average fees are between 2% and 5% of the loan amount similar to a traditional refinance or new home loan.
Always shop around and compare rates with several lenders before you decide to go for a refinance with withdrawal. You can do this easily with Credible. With Credible, you will be able to see actual prequalified rates in just three minutes.
Eligibility for cash refinancing
In addition to positive home equity, lenders have minimum borrower qualifications.
You can prepare for a withdrawal refi by meeting these basic requirements:
- Minimum credit score of 620
- Debt-to-Income Ratio (DTI) of 50% or less
- On-time payment history
- Earn constant monthly income
- At least 20% of the equity in your home
You must also use your funds for a qualifying reason, such as purchasing a second home to use as a rental property or vacation home.
Benefits of refinancing for the purchase of a second home
There are several advantages to choosing a cash-out refinance to buy a second home, including potentially lower rates and tax advantages:
- Potentially lower interest rate: Refinancing your mortgage means you can qualify for a better rate than the terms of your current loan. A withdrawal refi may also have rates lower than a second mortgage.
- Flexible payment options: Many lenders offer fixed APR repayment terms of 15 and 30 years. Longer loan terms can mean a potentially higher interest rate, but you have a smaller, more affordable monthly payment.
- Additional cash for the deposit: If you need a mortgage to buy another property, the withdrawal lump sum can be used as a down payment. This deposit can also help you avoid private mortgage insurance (PMI).
- Potential tax benefits: Depending on the purpose of the cash-out refinancing, you can claim a tax deduction. Two examples include improving the fixed assets of your primary residence or maintaining a rental property. Speak with your tax preparer to discuss the tax implications of a withdrawal refi.
Disadvantages of refinancing to buy a second home
Some of the downsides when refinancing to buy a second home include using your home as collateral and potentially paying higher closing costs:
- High closing costs: Mortgage refinancing can have relatively high closing costs between 2% and 5% of the total loan amount. A Home Equity Line of Credit (HELOC) can offer similar borrowing limits and potentially lower fees. Lenders can waive HELOC closing costs if you keep the line of credit open for a certain number of years.
- The main residence is collateral: Your primary residence is the collateral even if you are using the refinance to buy another property. If you default on the loan, the lender can foreclose on your primary residence.
- Higher monthly mortgage payments: Refinancing means that you may qualify for a lower interest rate, but the larger loan balance may result in a higher monthly payment. A mortgage payment calculator can help you determine how much equity you can leverage and what you can afford to pay monthly.
- Lump sum payment: Most home buyers can take advantage of the lump sum payment to afford a second home. However, homeowners with large cash reserves may prefer a line of credit to make multiple withdrawals and minimize interest charges.
Other Ways to Buy a Second Home Against Home Equity
Refinancing your mortgage to buy a second home may not be the best option if you don’t qualify for lower mortgage rates or want more flexible repayment terms.
If that’s not the best for you, lenders also offer additional options for using your home equity.
Home equity loan
Better if: You need a lump sum payment, but you don’t want to refinance your first mortgage.
A home equity loan is similar to a cash refinance because you get a lump sum payment of up to 85% of your current equity. Closing costs and redemption options are also similar.
Home equity loans may be the best option in these cases:
- You are not eligible for a lower interest rate: Although mortgage refinance interest rates are near their historic lows, the interest rate you qualify for may not be as low as your current rate. Therefore, your total borrowing costs could be lower if you skip refinancing and pay only the highest rate on the home equity loan.
- Minimize closing costs: A cash-out refinance requires you to pay closing costs on the entire loan amount. These fees can offset savings from a lower interest rate if you have a high mortgage balance. During this time, lenders may not even charge closing costs on home equity loans.
- Tax implications: Having separate loans can make your tax return preparation easier if you can deduct your principal mortgage interest. Interest paid on the equity in the home may be tax deductible, but the IRS states that the deduction only applies when you “buy, build or significantly improve the house” by securing the loan.
- Fixed monthly payments: Receiving a single lump sum distribution allows you to calculate your monthly payments and total loan costs.
Home Equity Line of Credit (HELOC)
Better if: You want to make multiple withdrawals and get a potentially lower variable interest rate.
A home equity line of credit may be a better option if you don’t want to take out a lot of your home equity all at once. During the loan withdrawal period, you can make withdrawals as needed up to your credit limit. Once the drawdown period is over, you will pay back what you borrowed.
Here are several key features of a home equity line of credit:
- Variable interest rate: Many HELOCs have a variable interest rate. These tend to be lower than the fixed interest rates for withdrawal withdrawals or home equity loans. However, variable rates – as the name suggests – can fluctuate and become higher in the future, potentially wiping out the initial interest savings.
- Draw period: Most lines of credit have a drawdown period of up to 10 years. During this period, you can borrow up to your credit limit if necessary. Once the draw period is over, you can no longer make withdrawals.
- Interest payments only: You only have to pay the interest during the drawdown period. After the withdrawal period is over, you have a fixed number of years to repay the principal plus interest charges. The repayment period varies depending on the lender, but can be up to 20 years.
- Reduced closing costs: HELOC closing costs may be lower than for a home equity loan. Compare several lenders, as some are more willing to waive the fees.
A HELOC is one of the most flexible ways to use the equity in your home. However, you need to be comfortable with a variable interest rate or find a lender that offers a fixed rate option.
Learn more: Home equity loan vs home equity line of credit