Funding a Vacation Home Purchase with Home Equity

Key Takeaways

• You can use funds from the equity you have built in your home to help finance a vacation home, either for a down payment or an all-cash purchase. 
• Loan-based options available to access your home equity include home equity loans and home equity lines of credit. 
• A home equity agreement offers a no-loan option to access your home equity. 

It’s the time of year for celebrations with family and friends. When you get together at the homes of relatives or friends, some of those homes may be vacation homes. If you’re thinking of purchasing a second home yourself, but worried about financing, tapping your home equity could be worth considering. Here, we explore how accessing home equity can help fund the down payment or make an all-cash purchase. We also review the pros and cons of different ways to access that equity. 

Ideally, you’d be able to save up to purchase a vacation home. But when that’s not realistic, using your home equity can be a strategic way to make your vacation home dream a reality. 

Option 1: Home equity loan 

Taking out a home equity loan (HEL) means you are taking out a loan against the equity you have built in your home. Home equity is defined as the current value of your home less what you owe on it. How much of that equity you can borrow depends on the lender, but it’s often 80% less the amount you owe on your home.  

With an HEL, you receive cash upfront. This gives you a sum of cash to use for a down payment on your second home, or to help with an all-cash purchase. You pay the loan back via a monthly payment that has a fixed interest rate. That means that neither the rate nor the monthly payment will change during the loan’s term. 

Qualifying for an HEL may be challenging for some homeowners, however. While each lender has its own criteria, most will require a credit score of at least 620. Some may require 680. The higher your score, the lower your interest rate (and monthly payment) will likely be.  

Lenders also will look at your debt-to-income (DTI) ratio. This is the percentage of your monthly income that goes to making payments on debts. Typically, a DTI of less than 36% is required, although some lenders – such as Fannie Mae – may accept a DTI that is higher. Stable income is a frequent requirement of the DTI equation. This can present an issue for homeowners who are retired or self-employed.   

The other ratio lenders look at is loan-to-value (LTV). This is the amount of the proposed HEL loan divided by the value of your home. Lenders usually require an LTV of 85% or lower.  

Option 2: Home equity line of credit 

Taking out a home equity line of credit (HELOC) is also taking out a loan against the equity you have built in your home. But unlike an HEL, you take out cash you need, when you need it, up to the limit extended to you. In this way, it works somewhat like a credit card. How much you can borrow is generally the same as with an HEL. 

For someone who needs a sum of cash to make a down payment or an all-cash payment on a second home, a HELOC may not be as helpful as an HEL. 

Also keep in mind that most HELOCs are variable-rate loans. That means the interest rate – and therefore the monthly payment – can vary over the life of the loan. The qualification criteria are the same as those with home equity loans.  

Option 3: Cash-out refinance 

With a cash-out refinance, you get a whole new mortgage to replace your existing one. The new mortgage is for an amount higher than what you owe on the existing mortgage, and the difference becomes the “cash out.” 

Two important considerations in a cash-out refinance are the amount of the new mortgage and the interest rate. The new mortgage, for a larger amount than your current mortgage, probably means that your monthly mortgage payment will be higher.  

Obtaining a new mortgage means you do so at current interest rates. Mortgage rates may be decreasing slightly, but they are still much higher than a few years ago when many homeowners secured an ultra-low rate. Unless you bought your home very recently – at current interest rates – the rate you’ll get in a cash-out refinance may be much higher than what you have on your existing mortgage. For this reason, cash-out refinancing may not be the best option for many homeowners. 

The application and qualification process for a cash-out refinance is the same as for a first mortgage, involving fees, closing costs, credit checks and documentation. 

Option 4: Home equity agreement 

A home equity agreement (HEA) is a no-loan option to access the equity you’ve accumulated in your home. You’ll receive cash upfront in exchange for a percentage of your home’s future value. An HEA is also sometimes called a home equity sharing agreement or home equity investment agreement.  

Because the HEA is not a loan, there are no interest fees. There are also no monthly debt payments to make. Homeowners end an HEA by buying back their equity at any time during the term of the agreement, which is often 10 years. Many people do this when they sell their home. Some HEA providers, like Unlock, allow homeowners to buy back their equity in partial payments at any time during the term of the agreement. 

For a homeowner taking on the additional expenses that go with owning a vacation home, not having another debt payment can be a real benefit. Plus, qualifying for an HEA can sometimes be easier than loan-based options. In fact, credit scores in the 500s may qualify, and income requirements are flexible – meaning that HEAs are available to retirees, self-employed individuals and others who may not have full-time traditional jobs or income. 

Pros and cons 

With each method of accessing your home equity, there are pros and cons to consider. 

• Qualification: Qualifying for a loan (HEL, HELOC, cash-out refinance) will involve a review of your credit, DTI and LTV. To get the best interest rate possible, you’ll need a high credit score. Lenders also typically need to see a source of stable income. HEA qualification criteria are more flexible, as the HEA is not a loan.  

• Loan payment: HELs, HELOCs and cash-out refinances are all loans. You’ll have an additional monthly payment to make, which your budget must comfortably support. You will not have an additional monthly payment with an HEA. 

• Collateral: With an HEL, HELOC or cash-out refinance, you’ll be using your primary residence as collateral. If you can not make your payments, you’ll run the risk of foreclosure on your primary residence. 

Making the decision 

Buying a vacation home is a major financial decision. The best method to finance the purchase will be different for each person, and using your home equity can be an excellent way to do so. If you’re interested in a loan-free option for financing a seocnd home purchase, Unlock’s HEA might be worth a closer look.