Whats The Difference Between A Second Mortgage Vs A Home Equity Loan
A home equity loan, or HEL, is one of two primary types of second mortgages. The second is a home equity line of credit or HELOC. The names of these two types of mortgages are very similar, and they often cause confusion among consumers. They are similar, but they have subtle and significant differences. A HELOC functions much like an extension of credit. You may borrow up to the limit of your equity, whereas a HEL gives you one lump sum of money upfront.
Typically, in a home equity loan, the lender will evaluate the amount of the equity and create a loan based on a percentage of that equity. The borrower is rarely allowed to borrow against the total amount of the equity. Instead, the lender will determine what percentage is acceptable to lend, and the interest rate is fixed based on the borrowers risk profile. The borrower receives the amount in one lump sum.
Cons Of A Second Mortgage
- Second mortgages have higher interest rates. Second mortgages often have higher interest rates than refinances. This is because lenders dont have as much interest in your home as your primary lender does.
- Second mortgages might put pressure on your budget. When you take out a second mortgage, you agree to make two monthly mortgage payments: one to your original lender and another to your secondary lender. This obligation can put a strain on your household finances, especially if youre already living paycheck to paycheck.
Can I Afford A Second Home
Are your finances ship-shape to the point that you can afford to buy a second home? Even if you plan to collect rental income from the property, youll want to be sure its a purchase you can afford, particularly if it will remain vacant for several months a year.
Here are some financial factors to bear in mind.
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Any Other Options For Financing A 2nd Home
If you dont pay cash for a second property, youll have to make a second mortgage payment. Borrowers with enough equity in their first property, on the other hand, can use that value to finance a second home. Some homebuyers use a cashout refinance to gain access to home equity by refinancing their current mortgage loan into a larger one and then using the lump sum of cash left over as a down payment on a second mortgage. A home equity loan or home equity line of credit could give second home buyers access to up to 80% of the value in their home if they have recently refinanced or just do not want to pay closing expenses.
Interest Rates Will Likely Be Lower
Lenders spend less time originating home equity loans, which may save you money, as it typically means lower fees and closing costs. But perhaps the biggest advantage of this option is the potential to lower your interest rates.
Home equity loans offer lower interest rates because they are secured by collateral in the form of real estate. This means by utilizing a home equity loan, you can avoid the hefty interest rates you would encounter through other forms of financing, like hard money and personal loans.
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What Is A Heloc
Sometimes known as a home improvement line of credit, a HELOC is a type of home equity loan that acts as a revolving line of credit that you can access continually over a period of time. If you need money to pay for longer-term home improvement projects in which costs can fluctuate, a HELOC is an ideal option because you can repeatedly withdraw money over the course of your loan to fund your projects.
The period of time in which you can withdraw money from your line of credit is known as the draw period. It typically lasts 10 years. If you need to access money, but are uncertain as to how much youâll need , then a HELOC is the type of loan you need.
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Shop Around For Lenders And Rates
You can look for HELOC lenders online and/or at brick-and-mortar financial institutions and get preapproved. Experts recommend getting preapproved with at least three different HELOC lenders so you can find the best deal on your loan. Compare loan offers and terms carefully, including the initial interest rate, draw period, repayment period, costs, fees, penalties, and restrictions about how the money can be used.
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Down Payment: 15% To 25%
Down payment requirements for an investment property range from 15% for a one-unit property to 25% for a two- to four-unit property. You may also be required to make a bigger down payment depending on your application and the type of loan you qualify for.
Private lenders sometimes called hard money lenders might also make asset-based loans. The borrower puts down 30% or 40% of the purchase price and the lender provides the balance.
Flippers often use such short-term mortgage loans to finance their deals. However, this can be risky. If the property does not sell for enough to cover the loan amount, or if the property does not sell at all, the borrower can face foreclosure and the loss of all equity.
Buying A Second Property
If youre thinking about buying a second house, like an investment property, a second mortgage can help you achieve that goal. Here are a few things to know first:
- For second properties a down payment of at least 20% is required for a second mortgage.
- If you or family members are going to live in the second home rent-free, you can pay less than 20% down payment.
- The Canadian Home Buyers Plan, which allows you to tap into your RRSPs, doesn’t apply on a second property.
- Costs are much the same as your first purchase: valuation fees, legal fees, and registration fees.
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What Is An Investment Property
An investment property, on the other hand, is one that you purchase with the explicit intention of generating income. The investment property could be right next door to your own home, or it could be in another stateit doesnt really matter. Youll be playing the role of landlord, with long-term or short-term renters paying cash to stay in the home.
Never forget that an investment property is all about the Benjamins, says Lamar Brabham, CEO and founder of financial services firm Noel Taylor Agency. The entire point is to turn a profit. No emotions, no affection.
Before making an offer on an investment property, youll want to crunch the numbers to make sure its a solid investment. Similarly, consider what factors will be important to prospective tenants .
What Is The Process Of Buying A Second Property
The idea of buying a second property used to be reserved for those who were well-heeled. Not anymore. Whether its used as a vacation property, a rental property, or to prepare for retirement, more and more middle-class Canadians are purchasing a second property. Younger Canadians are also thinking about buying a second property 65% of Millennials, aged 18 to 34 are interested in purchasing a cottage, cabin, or chalet.
Whether its a lakefront cottage, cabin in the woods, condo in downtown Toronto, or a suburban home youre thinking of investing in or fixing up and flipping, you need to be aware of what you are getting into. That includes the mortgage approval process, refinancing options, and whether you can use a home equity line of credit .
Below are some answers to popular questions when purchasing and financing a second property.
Can You Afford a Second Property?
Lots of people want a buy a second property, but you need to ask yourself if you can afford it and if so, how you can get the best financial products at the best rates. While interest rates in Canada are on the rise, they still remain near record lows, which means its the perfect time to look at buying a second property.
What Are Your Financing Options?
Refinancing
A Second Mortgage
Like the primary mortgage, you make monthly payments on the second mortgage. A second mortgage is a great option for those who can comfortably afford to make two monthly mortgage payments.
Home Equity Line of Credit
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Claiming Mortgage Payments On Rental Property
You can deduct mortgage interest payments to lower yourtaxable income in Canada. However, you can only do this with investment properties and not primary residences. You must factor out your proportionate square foot percentage from the deduction if you live in a unit. For example, if you own a 5,000 sq ft. rental property and inhabit a 1,250 sq ft. unit, then you can only deduct 80% /5000) of themortgage interest costs.
Determine How Much Equity You Have
Remember that when you take a HELOC on an investment property, youll likely need to leave 25% of your equity untouched. So you need more than 25% accrued to qualify.
For example: Say your rental property is worth $500,000 and you own $300,000 on the original mortgage. You have $200,000 in home equity, or 40%. If your lenders maximum loan-to-value for an investment property is 75%, the most you can borrow in total is $375,000. After subtracting the existing mortgage amount , youre left with a maximum potential HELOC amount of $75,000.
Your home equity level can be calculated by subtracting any outstanding mortgage balance from the current market value of your property, says Boyd Rudy, associate broker with Dwellings Michigan. The lender will likely require an appraisal to determine your propertys current value, but you can use the purchase price or an online estimator like Zillow to get a ballpark number.
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Home Equity Of 20% Or More
Homeowners will need more than 20% equity in their primary residence to qualify for a cash-out refinance. You typically have to leave 20% of the homes value untouched, which means that you can only cash out the amount of equity you have above that threshold.
Leaving 20% equity in the home also has an advantage: the borrower dodges Fannie Mae and Freddie Macs private mortgage insurance requirement.
However, an FHA loan will require FHA mortgage insurance premiums even with 20% equity left in the home.
Turn To A Local Bank Or Broker
If your down payment isnt quite as big as it should be or if you have other extenuating circumstances, consider going to a neighborhood bank for financing rather than a large national financial institution.
Theyre going to have a little more flexibility, Huettner says. They also may know the local market better and have more interest in investing locally.
Mortgage brokers are another good option because they have access to a wide range of loan products but do some research before settling on one.
What is their background? Huettner asks. Do they have a college degree? Do they belong to any professional organizations? You have to do a little bit of due diligence.
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Second Home And Investment Property Basics
In addition to a primary residence, homeowners may have a second or vacation home, as well as investment properties that are rented to third parties for income. The primary residence is where the owner lives most of the year.
Second homes are properties such as vacation homes that the owner personally occupies for more than 14 days per year, while still also maintaining a primary residence. Its possible to have more than one second home.
Its also possible to generate income by renting a second home to third parties for part of the year. The property will meet the definition of a second home, rather than an investment property, as long as the owner lives there for a number of days equal to at least 10% of the days the home is rented or 15 days a year.
Investment properties dont have any occupancy requirement. They can be rented out 365 days a year to third parties. Rentals may be long-term, such as on an annual lease basis or short-term. Owner make money on investment properties from rental income and appreciation and gain tax deductions they can use to shelter income.
Second Homes Vs Investment Properties
The difference between second homes and investment properties is that a second home is a property that you occupy for a portion of the year. In contrast, an investment property is a property that you do not live in for any portion of the year and instead own for income-generating purposes. You will find that mortgage rates and down payment requirements are higher for investment properties than for second homes. This is because lenders find that homeowners are more likely to stay in possession of second homes than an investment property if they were ever to find themselves in financial trouble. The requirements are similar for both forms of properties, but lenders may require that a borrower has experience managing properties before approving a loan for an investment property.
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Financing Second Homes And Investment Properties
When applying for a mortgage, a borrower has to indicate whether the property will be used as a primary residence, second home or investment property. Primary residences are the easiest and least expensive to finance, with looser qualification standards and lower interest rates. Down payments on primary residences may be as low as 3% of purchase price on conventional loans, 3.5% on FHA loans and zero on VA loans.
Lending requirements on second homes are stricter. Lenders are likely to look for a lower debt-to-income ratio to be sure the buyer can cover the second mortgage payment, for instance. Second-home mortgages may require 10% down. Interest rates are also likely to be slightly higher than primary home mortgages. Except for a few special circumstances, FHA loans cant be used to purchase second homes.
Investment property is the hardest to finance. Lenders call for down payments of 25% or so and also prefer higher credit scores. Government-backed lending programs generally cant be used to buy investment property. Financing an investment home is likely to involve paying more interest and additional fees to the lender. However, borrowers can often use the projected rental income to help them qualify for an investment mortgage.
Mortgage Considerations When Changing A Second Home To An Investment Property
You may be asking yourself, can I turn my second home into a rental property if I have a mortgage on it? The short answer is yes, but there are several considerations. In particular, you must consider the terms of your existing mortgage before converting a second home to a rental property.
Most second home mortgages have more favorable terms than loans for an investment property. Lenders usually require lower down payments and offer interest rates lower than they would for an investment property. Its against the law to make your property look like a second home when you intend to use it as an investment property. As such, misrepresenting the homes use has legal and financial implications.
Lenders, however, cant do much about a legitimate change in occupancy during the term of your mortgage. Just be aware that a change in your homes occupancy status within the first 12 months of ownership may invite greater scrutiny from your mortgage provider. Further, when your mortgage comes up for renewal, your mortgage provider may choose not to renew your mortgage at all given the change in use designation and increased risk profile. Alternatively, if you refinance later down the road, you must also disclose the change in occupancy and secure an investment property loan versus a second home mortgage which may have different terms.
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A Second Mortgage Is A Tool Use It As Such
Second mortgages offer you the opportunity to use the equity in your home for a number of different situations. If you have bad credit and need to consolidate debt, pay off other loans, renovate your home, invest, a downpayment on your next property, funds to support yourself while selling, paying off property or tax arrears, or need emergency funds, a second mortgage is a great tool for Canadians to improve their financial well-being. Be sure to consult the right mortgage professional in your area to discuss your specific situation, and how a second mortgage can help you.
You Are Trading Assets In For Debt
Getting a home equity loan means turning assets into debt because you are effectively taking the part of your home that you own and tying it up in another loan. Although this may be worth it in some scenarios as it prevents you from having to withdraw money from existing investments, there are also implications to having higher debt that you must consider.
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Example Of Using A Heloc As A Second Mortgage
A HELOC is a revolving line of credit that operates like a credit card. Because the interest rate is often variable, your monthly payments can go up and down and wonât be consistent.
So, for example, letâs say your lender approves you for a $20,000 HELOC. You spend a total of $15,000 to remodel your kitchen. If you pay back the $15,000 within the draw period, then you can use the $20,000 again for another major expense, provided itâs within the draw period.
Lenders typically give homeowners a draw period of 10 years to take out cash from the loan. During that period, homeowners are only responsible for making payments on the interest and not the full loan amount. The loan gives you another 20 years to pay back the amount you borrowed along with the interest.
