Homeownership offers many benefits — one of which is tapping your equity for financial empowerment. Mortgage holders have long leveraged equity to achieve their dreams, from funding education and home improvements to paying off high-interest debt.
In this post, we'll explore the ins and outs of using equity as a down payment for a new home and the benefits and drawbacks of doing so.
Can you use home equity for a down payment?
If you’ve built equity over the years, you can take advantage of it to put a down payment on a new home or a second property. Using home equity to achieve your financial goals is not only a common practice but can provide a lower-cost way to finance your down payment. Here are the pros and cons of leveraging your equity to buy a property:
- Access to funds: Your equity provides a readily available source of cash and mitigates the type of financial vulnerability that comes with draining your reserves.
- The chance to put more down: There's the potential to make a larger down payment — or even the entire cost of the property — since many equity products allow you to borrow large amounts. As a result, you would save on the new mortgage and avoid PMI insurance.
- Lower interest rates: Equity products typically offer lower rates than credit cards or personal loans.
- Flexibility: With so many products on the market, homeowners can choose the terms and repayment structure they agree to. If you shop around, you can find a product best suited to your needs.
- Interest: While rates are lower, you’re still on the hook for paying interest on what was borrowed.
- Closing costs and fees: There are upfront costs with products like HELOCs and home equity loans. You'll have to budget for these and the expenses related to purchasing a new house. Fees are typically anywhere between 2%-5% of the total loan amount.
- Financial health impact: Equity financing increases your debt obligation, which impacts factors like your credit score and debt-to-income ratio. This can put you at risk of being approved for other financing opportunities, like securing funds for renovations
- Risk of foreclosure: Using your home as collateral puts it at risk. If you can't cover the expenses associated with two houses, you could lose your home.
How to use home equity for a down payment
First, it’s important to assess your financial situation. Start by determining the amount of equity you have in your home and how much you want to finance. Additionally, review key health metrics that lenders take into consideration, such as
- Credit score: Requirements vary from lender to lender.
- Debt-to-income ratio: DTI is a percentage that represents your total monthly debts divided by your gross income.
- Loan-to-value (CLTV) ratio: A measurement comparing what you owe on your mortgage to the appraised value of your property.
- Income: Requirements vary from lender to lender, but most require proof of a steady and reliable income.
Then, compare products and lenders that fit your needs. Spending extra time finding a lender with a slightly better rate can save you thousands of dollars over the life of your loan.
Finally, once you’ve decided which option is best, you can initiate financing and obtain your funds.
Ways to draw on your home’s equity
Home equity loan
A home equity loan, or second mortgage, allows you to borrow against your equity for a lump-sum payment. These loans offer a fixed interest rate, typically more competitive than credit cards or personal loans. Borrowers repay the principal and interest via fixed monthly payments over a 30-year term.
General requirements: You’ll need a minimum credit score of 680, a CLTV of less than 80-85%, and a DTI of less than 43%. Some lenders are willing to work a credit score minimum of 620.
Good for: Borrowers who are comfortable making fixed monthly payments over a longer term.
Home equity line of credit (HELOC)
You can also use a HELOC for a down payment. HELOCs offer a secured, revolving line of credit that works similarly to a credit card. During the draw period, which is typically between five and ten years, you can borrow funds up to a predetermined balance whenever you need them. Once the draw period ends, the repayment period begins, and your outstanding balance is converted into a principal-plus-interest loan. HELOCs have variable interest rates that fluctuate with market conditions.
General requirements: You’ll need a minimum credit score of 680, a CLTV of less than 85%, and a DTI of less than 43%. Some lenders are willing to work a credit score minimum of 620.
Good for: Borrowers seeking flexibility in how much and when they can access their funds.
A cash-out refinance replaces your existing mortgage with a larger one, allowing you to pocket the difference in cash. What you’ve borrowed is added to your home loan, leaving one larger monthly payment.
Your newly refinanced mortgage will have payment terms and fixed rates similar to a traditional mortgage. A cash-out refinance will displace your current rate, so it may not be worth pursuing, depending on the economic environment.
General requirements: You’ll need a minimum credit score of 620, a CLTV of less than 80%, and a DTI of less than 43%.
Good for: Borrowers who are seeking cash and can change their mortgage rate and term for the better.
Home Equity Investment
A Home Equity Investment (HEI) is another product that enables you to tap into your equity for cash. You can access a lump sum to meet your needs in exchange for a portion of your home's future appreciation. There are no monthly payments; homeowners can buy back their equity anytime during a 30-year term when they decide to sell their home or leverage a cash-out refinance.
General requirements: You’ll need a minimum credit score of 500 and a CLTV of less than 70%.
Good for: Borrowers who want to avoid monthly payments or desire less strict requirements.
Is it a good idea to use home equity for a down payment on a new home?
There are many situations where using home equity for a down payment is a good idea. For example, if you're moving for work and want a bridge loan with better terms or want to grow your wealth through an investment property. Using home equity for a down payment on a second home can provide you access to money today and more flexible terms.
Assess your financial situation to determine if you can manage all monthly payments involved until you can sell your primary residence or start seeing an ROI on an investment property. If you decide to let your equity work for you, you'll want to weigh the options carefully, as each offers different requirements, repayment terms, and costs. Today's high-interest environment may make some options more or less attractive.
Home equity is a powerful tool that can provide an affordable and flexible source of funds for a down payment. Finding the right product hinges on your unique situation, needs, and preferences. Remember to compare products and lenders to determine what's best for you.
With Point's Home Equity Investment, there are no monthly payments, no income requirements, or the need for excellent credit. See how much you can qualify for by visiting Point.com.