How to use your home equity to buy a second home in Canada

Using home equity to buy a second home is an excellent opportunity for homeowners to access built-up equity without selling their homes.

Borrowers can tap this home equity for many reasons like medical expenses, renovations, college funds, etc. But increasingly, homeowners are using home equity for other investments, including a second home.

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What Is home equity?

In short, home equity is the amount of the home that a borrower owns as they pay down their mortgage, and it appreciates in value with the price of their home. On average, home prices rise each year, so as homeowners pay down their mortgage, their share in the property goes up.

Many borrowers wonder, “Can you use home equity to buy a second house?” The answer is yes, but the amount of equity the borrower has in the property influences how much money they can borrow.

As a borrower pays off their principal loan balance over the years, the percentage of the home they own goes up. The part of the loan that has been paid is called equity.

Calculating your home equity is made a little more complex because of the interest paid on the mortgage. However, a rough example is:

A borrower purchases a home for $100,000. They have paid $80,000 of principal loan (i.e., excluding interest rates). Therefore, the borrower has $80,000 equity in their home.

To tap this equity, the homeowner can either:

a) sell the property

b) get a home equity loan or line of credit

In this article, we’ll look at how borrowers can use their home’s equity to buy a second home.

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What kinds of properties can you buy with home equity

Typically, there are two types of properties that see borrowers using equity to buy a new home.

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Rentals

Purchasing a home or condo and turning it into a rental can be a smart way to use home equity. The rental income can pay off the loan or become its own source of income, with the bonus of the property appreciating too.

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Vacation Homes

Having a vacation home is the dream for many homeowners. A vacation home can become a hub during the summer months or the holidays– bringing together family and friends from all over. Additionally, it can be an escape during the cold winter months or weekend getaways.

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How to finance a second home

Before anyone commits to buying a new home, they should first figure out how they plan to finance it. Another significant consideration is the additional expenses that go along with rental or vacation homes.

While the cost of a condo or a vacation home can be pretty reasonable, borrowers need to consider the:

• extra monthly payments
• interest on the mortgage
• homeowner's insurance
• property taxes
• homeowners association dues
• utilities
• maintenance
• loan closing costs

For Borrowers, there are several loan options when buying a new home.

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Cash

Cash is still a surprisingly common way for homeowners to purchase a home.

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Conventional loan

A conventional loan is another option for a second property, but there are many drawbacks to consider. The approval restrictions are tighter than they would be for a primary mortgage, with a downpayment of 20-35% not uncommon for many lenders. Additionally, conventional loans can carry higher interest rates which can make them questionable investments.

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Home equity loan

For many borrowers, a home equity loan is a great option. However, this is dependent on having enough equity tied up in a property.

It's important to note that applying for a home equity loan has some extra criteria beyond having a large amount of equity in the property. Many lenders will look for a higher credit score rating and a lower debt-to-income ratio than they would for a primary mortgage.

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Can you qualify to use equity to buy a new home?

For borrowers leveraging their home equity to buy a new home is the most straightforward and cheapest option.

Because home equity loans are backed by real property, they feature some of the most favorable rates on the market. Home equity lenders will generally offer far better terms than personal loans.

Other routes that borrowers can take towards buying a second home can be arduous. Firstly, lenders will frequently scrutinize an applicant for a second home with harsher criteria.

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Credit score checks

Most lenders will require a credit score check to ensure that they aren't extending a line of credit that is too risky. A second home means enhanced debt, so parties with a history of loan delinquency will have difficulty accessing a second mortgage.

These stricter terms could mean a credit score of 620 or higher with most lenders. Additionally, many lenders might require a debt-to-income ratio of 43% or lower.

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Income checks

In many cases, taking out a second mortgage means either:

a) having two monthly payments

b) rolling both payments into one

Most lenders will require proof that a borrower can keep up with these payments via their monthly income. Again, because the property concerned is a second home, income checks will be rigorous to ensure that the odds of the borrower defaulting are low.

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How much equity do you have?

Most lenders require borrowers to have 80% of home equity to borrow against a property.

So, the amount of equity and the home's appraised value are the factors that determine how much a borrower can access.

Use our home equity calculator to find out how much you can borrow.

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Loan to value ratio

Loan to value ratio (LTV) is a calculation that banks and financial institutions make to determine lending risk. A loan to value ratio is calculated by the amount borrowed divided by the property's appraised value.

For example, a home appraised and purchased $200,000 with a downpayment of 10% — or $20,000 — will have an LTV of 90%. i.e. (180,000/200,000 = 90%)

However, for borrowers considering how to use equity to buy a second home, this calculation becomes more complex and requires a combined loan to value ratio (CLTV).

The CLTV will look at both the primary and secondary mortgage. Most lenders will be happy to work with borrowers with a CLTV of 80% and above, provided they have respectable credit scores.

This highlights one of the benefits of unlocking home equity to purchase a second home. By putting more money down, the CLTV will be far lower, meaning a lender will be more willing to do business.

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Benefits of using home equity to buy a second property

1. Keep your investments working

Often borrowers will draw from their investment funds, IRAs, shares, or cash savings to pay for a second property. This method can be suboptimal and constitute critical opportunity costs.

S&P 500 tracker funds have grown by 100% over the last five years. Other specific investments have exploded. While house prices appreciate, it's typically not at these levels.

Home equity can be hard to access without selling the home. So, using home equity to purchase a second home is a more intelligent move.

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2. Lower fees and closing costs

First-time mortgages cost lenders a lot of originating time; home equity loans less so. Additionally, because the loan is secured with the house as collateral, lenders can charge far lower interest fees.

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3. Using equity to buy a second home can be less risky in volatile markets

Taking out a second mortgage means borrowers must service two monthly loans. Using home equity can significantly reduce monthly payments.

If a borrower purchases a rental property and the rental market collapses, this can leave them with high monthly obligations. However, a rental home purchased with home equity provides more manageable payments.

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Disadvantages of using home equity to buy a second property

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1. Risk of foreclosure

Many financial institutions are happy to grant loans backed by equity because they are secure in the case of delinquency. The economy, health, or job prospects can take a dark turn at any time, leaving borrowers struggling to make payments. In the worst-case scenario, they could lose their home to foreclosure.

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2. Loan costs

Second mortgages can be expensive and come with high loan and closing costs.

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3. Interest rates

Many of the options for unlocking home equity will involve refinancing an existing mortgage. These second mortgages typically have a higher interest rate than a primary mortgage.

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Why Fraction?

A Fraction Mortgage is the best and fairest way for homeowners to tap the built-up equity in their existing homes to either purchase or put towards a downpayment on a second home.

These arrangements address some of the most significant issues facing borrowers looking to use home equity to purchase a second home.

Instead of applying for a home equity loan that will involve excessive monthly payments, Fraction allows you to access the equity in your current home. This money only needs to be paid back when you either sell or leave the home. This means no monthly payments that put your home at risk of foreclosure.

Secondly, these loans are taken out with fair interest rates that will adjust and serve you well during either a boom or a bust market.

So, if you're wondering how to use equity to buy a second home in Canada, use the calculator provided below to find out how much you can borrow. With no age or income restrictions and rates that are always fair and transparent, you could leverage unlocked home equity to buy a second home or rental property.

Additionally, if you are buying a second home, and you have 60% down, you can use Fraction to skip the monthly payments, meaning your dream can quickly become a reality.

Find out how equity you can unlock with our easy-to-use calculator!