Are you in the market for a second home? If you’re short on the cash needed for the down payment but have sufficient equity in your current property, a HELOC could be an option to help you seal the deal.
Read on to learn more about HELOCs, how they work, and the pros and cons of using one for a down payment. You’ll also gain insight into the eligibility guidelines for these home equity products and how they differ from other financing options that can also be used for down payments on additional properties.
What is a HELOC?
A home equity line of credit, or HELOC, is a type of loan that lets you borrow against your home equity. It’s not an installment loan, though, but a revolving line of credit that works like a credit card.
How Does a HELOC Work?
You can borrow up to a certain limit set by your lender—typically up to 85% of your home equity or the amount of your home you own outright. To illustrate, if you owe $265,000 on a home worth $400,000, you could access a HELOC of up to $75,000 ($400,000 * .85 – $265,000).
When the HELOC is open, you’re free to make withdrawals up to the credit limit. As you make payments and the line replenishes, you can borrow again until the draw period ends. You’ll then repay the total amount borrowed over a 10- to 20-year period.
Keep in mind that most lenders permit interest-only payments on HELOCs during the draw period to make HELOCs more manageable.
Overview of Down Payments in Real Estate
A down payment is the amount you pay upfront to secure a real estate loan used to purchase a property. It’s typically a percentage of the home’s purchase price.
The exact amount depends on the lender, loan program and loan type. Here’s a general guideline:
- Primary residence: 3% to 20% of the purchase price (some government-backed loans do not require a down payment)
- Second home: up to 30% of the purchase (depending on if you’re purchasing a vacation home or investment property)
Can You Use HELOC for a Down Payment?
Yes, you can use the funds from a HELOC for a down payment, as there are no spending restrictions. It could actually be in your best interest to do so, particularly if you’re approved for a large credit line. If you begin with at least 20% in home equity, you can borrow less to secure the property and avoid private mortgage insurance (PMI).
The Pros of Using a HELOC for a Down Payment
Here are some advantages of using a HELOC for a down payment:
Access to Funds
Again, a HELOC lets you convert a portion of your home equity into cash. A considerable amount of home equity could equate to more borrowing power, assuming you meet the lender’s other eligibility criteria.
Potential Tax Benefits
You could potentially benefit at tax time with a HELOC. If the loan proceeds are used to buy, build or significantly improve the property secured by the HELOC, the interest you pay on the HELOC could be tax deductible. Consult with a reputable tax advisor to learn more.
Flexibility and Convenience
HELOCS are far more flexible and convenient than traditional loan products. You can borrow as needed, which means you somewhat control borrowing costs. And you only pay interest on the funds you access.
The Cons of Using a HELOC for a Down Payment
There are also downsides to consider when deciding if a HELOC is ideal to fund a down payment:
Impact on Home Equity
Taking out a HELOC eats into your home equity. If market conditions trend downward, the fair market value of your home could follow suit and put you underwater on your mortgage. In this case, you could find it harder to sell or refinance your home in the future.
Interest Rates and Market Conditions
Since the interest rates on HELOCs are fixed, you can expect monthly payments that change over the draw and repayment periods. Remember, rates are based on market conditions, so if they increase significantly over time, your monthly HELOC payments can skyrocket and become unaffordable.
Repayment Terms and Fees
It’s not uncommon for HELOCs to have application fees and ongoing maintenance costs, along with fees for each transaction. Late fees also apply if you’re unable to make timely payments.
Risk of Overborrowing
A relatively large line of credit through a HELOC could open the door to the temptation to spend more than you need or can actually afford to repay. And if you aren’t disciplined enough to resist the temptation, you could find yourself in a mountain of debt with hefty, unaffordable loan payments to match.
What are the Eligibility Requirements for Securing a HELOC to Make a Down Payment?
Each lender has its own requirements, but having an idea of what to expect can help you avoid disappointment or surprises during the application process. Here are some general guidelines for HELOCs to keep in mind before formally applying for funding.
Credit Score Requirements
A strong credit score is ideal – think 700 or higher. That said, you could qualify with a score as low as 620, but the terms you receive won’t be as attractive.
Home Equity Requirements
Lenders require you to have at least 15% or 20% in home equity to qualify for a HELOC. The more equity you have, the better your approval odds, assuming you meet the other lending criteria.
Documentation Needed
Gather the documents you’ll need in advance to avoid hiccups in the processing of your application. Be sure you have recent pay stubs, tax returns, bank statements and W-2 forms handy. The lender may also request information about your property, along with your existing assets and debts.
Application Steps
Here’s what to expect when you apply:
- Step 1: Evaluate the eligibility guidelines to ensure you qualify.
- Step 2: Gather the necessary documentation.
- Step 3: Formally apply for a loan and include documents the lender needs.
- Step 4: Await the results of the home appraisal.
- Step 5: Receive final approval from the underwriting department.
- Step 6: Review the loan documents and close on the HELOC to seal the deal.
How Does a HELOC Compare vs. Other Financing Options for Down Payment?
Here’s how HELOCs stack up to the competition:
- Home Equity Loan: A home equity loan provides a lump sum of cash at once, payable over a set period. It also comes with a fixed interest rate and equal monthly loan payments.
- Cash-Out Refinance: This involves refinancing your existing mortgage with a new, larger one and receiving the difference in cash. The variance is the amount of home equity you pull out.
How to Use a HELOC for a Down Payment Safely
If you’re leaning toward using a HELOC to help fund the purchase of another home, keep these tips in mind.
Calculating How Much to Borrow
Be sure to run the numbers to determine how much you can borrow. Also, shop around and compare loan quotes to ensure the terms and proposed payments once you make draws work for your budget.
Managing Monthly Payments
Again, assess your budget before taking a HELOC to determine if the extra monthly payment fits alongside your existing obligations. If possible, aim to make payments above the minimum to reduce your debt quicker and save on interest over time.
Remember, missed payments can lead to penalties and increased interest rates. However, enrolling in autopay can help you avoid this issue.
Monitoring Interest Rates
Most HELOCs come with variable interest rates, which means your monthly payments will fluctuate over time. So, keep tabs on current market trends and economic conditions as they impact the direction of interest rates.
Should You Use a HELOC for a Down Payment?
It depends on your unique financial situation. Using the funds from a HELOC to cover the down payment on a second property could be a smart financial move and help you keep more of your hard-earned money in your savings account. But it’s not without risks. Weight the pros and cons of this approach and run the numbers to make an informed decision.
