How home equity works as down payment money

If you own a home, you can borrow against the difference between what it is worth and what you still owe on the mortgage. That borrowed money is called a home equity loan or home equity line of credit (HELOC), and you can use it for a down payment on another property. The lender takes a second mortgage on your house as collateral, meaning if you stop paying, they can foreclose.

The amount you can borrow depends on your home's current value, how much you still owe, and your credit score. Most lenders let you borrow up to 80 or 85 percent of your home's total value, minus what you owe. If your house is worth $300,000 and you owe $150,000, you might borrow up to $90,000 (85% of $300,000 minus $150,000). That money arrives in your bank account within days or weeks, ready to use for a down payment.

The risk is real: you are putting your current home at stake. If you cannot pay back the home equity loan, the lender can force a sale. You also take on a second monthly payment, which affects how much you can borrow for the new mortgage.

Key Takeaways

  • A home equity loan or HELOC lets you borrow against your home's value and use that cash for a down payment on another property.
  • Most lenders allow you to borrow up to 80 to 85 percent of your home's value minus what you still owe on the first mortgage.
  • The second mortgage payment reduces the income available for your new mortgage, so lenders will approve you for less on the purchase.
  • Home equity loans have fixed rates and fixed terms; HELOCs have variable rates and work like a credit card you draw from as needed.
  • If you cannot pay the home equity loan, the lender can foreclose on your current home, not just the new one.

Home equity loan versus HELOC: which structure fits your timeline

A home equity loan works like a traditional mortgage: you borrow a lump sum, receive it all at once, and pay it back over a fixed term (usually 5 to 15 years) at a fixed interest rate. You know your monthly payment from day one. This is the simpler choice if you need all the down payment money right away and want predictable payments.

A HELOC is a revolving credit line, similar to a credit card. You are approved for a maximum amount, but you only borrow what you need, when you need it. Interest rates are variable, meaning they move with market conditions. Many HELOCs have a draw period (usually 5 to 10 years) when you can withdraw money, then a repayment period (10 to 20 years) when you pay it back. During the draw period, you may pay interest only; during repayment, you pay principal and interest.

For a down payment, a home equity loan is usually the better choice because you need the money in one chunk and want to lock in your rate before closing on the new house. A HELOC makes sense if you are unsure how much you need or plan to use the line for other expenses over time.

How the second mortgage payment affects your new mortgage approval

When you apply for a mortgage on the new property, the lender calculates your debt-to-income ratio (DTI): the total of all your monthly debt payments divided by your gross monthly income. Most lenders want your DTI below 43 percent. The home equity loan payment counts as debt.

If you borrow $50,000 on a 10-year home equity loan at 8 percent interest, your monthly payment is roughly $607. That $607 reduces the income available for your new mortgage. If you earn $5,000 per month, your existing debts (car loan, credit cards, the home equity payment) might total $1,500, leaving only $3,500 for the new mortgage payment. A lender might approve you for a $500,000 house without the home equity loan but only a $350,000 house with it.

Before taking out a home equity loan, ask your mortgage lender how much it will reduce your purchasing power. Some borrowers find that using home equity for a down payment actually shrinks the total home they can afford.

Steps to borrow against home equity

Start by getting your home appraised or finding its current market value using online tools like Zillow or your county assessor's website. Contact your current mortgage lender first—they already know your payment history and may offer better rates than a new lender. If you want to shop around, contact banks, credit unions, and online lenders.

You will need to provide recent pay stubs, tax returns (usually two years), bank statements, and proof of homeowners insurance. The lender will order an appraisal, which typically costs $300 to $500 and takes 7 to 10 days. Once approved, you sign closing documents (similar to a mortgage closing) and receive the funds, usually within 3 to 5 business days.

The entire process takes 2 to 4 weeks. If you are buying a new home, start the home equity application early—ideally before you make an offer—so the money is ready when you need it. Some lenders allow you to close the home equity loan and the new mortgage on the same day, but this requires coordination between both lenders.

Interest rates, fees, and the total cost of borrowing

Home equity loan rates are typically lower than credit card rates but higher than first mortgage rates. As of early 2024, rates vary by lender and credit score but generally range from 7 to 10 percent, though this changes with market conditions. HELOCs often start with a promotional rate (sometimes as low as prime rate) for the first 6 to 12 months, then adjust upward.

Closing costs for a home equity loan run 2 to 5 percent of the borrowed amount. A $50,000 loan might cost $1,000 to $2,500 in fees, including appraisal, title search, origination fee, and attorney fees. Some lenders waive closing costs to attract borrowers, but this usually means a higher interest rate.

Calculate the true cost before borrowing. A $50,000 home equity loan at 8 percent over 10 years costs about $36,000 in total interest alone. If you can avoid the second mortgage by saving for a larger down payment or using a lower down payment option (like an FHA loan with 3.5 percent down), you may come out ahead.

Tax deduction rules for home equity interest

Under current tax law, you can deduct interest on a home equity loan only if the borrowed money is used to buy, build, or substantially improve the home that secures the loan. Using home equity to buy a second property does not may have access to for the deduction. Using it to pay off credit card debt or fund a vacation also does not may have access to.

If you use the home equity loan to improve your current home (a new roof, kitchen renovation) and then use other savings for the down payment on the new house, you can deduct the interest. But if you use the borrowed money directly for the down payment, you cannot. Consult a tax professional before borrowing to confirm your specific situation.

Alternatives if home equity is not available or too risky

If your home has little equity, you cannot borrow enough, or you do not want to risk your current home, other options exist. A gift from a family member counts as down payment money and does not require repayment or affect your debt-to-income ratio. Most lenders require a signed gift letter stating the money is a gift, not a loan.

An FHA loan allows down payments as low as 3.5 percent, meaning you need less cash upfront. A conventional loan with a lower down payment (5 to 10 percent) is also possible if your credit is good; you will pay private mortgage insurance (PMI) until you reach 20 percent equity, but you avoid the second mortgage.

A personal loan from a bank or credit union can fund a down payment without using your home as collateral, though interest rates are higher than home equity loans. Some employers offer down payment assistance programs or loans to employees. If you are a first-time buyer, state and local programs may offer grants or low-interest loans.

Frequently Asked Questions

Can I use a home equity loan if I still owe a lot on my first mortgage?

Yes, as long as you have equity. If your home is worth $300,000 and you owe $250,000, you have $50,000 in equity and may borrow against it. Lenders typically allow you to borrow up to 80 to 85 percent of the home's value, minus what you owe on the first mortgage.

What happens if the housing market drops and my home loses value?

You still owe the full amount you borrowed. If your home drops from $300,000 to $250,000 and you borrowed $50,000, you now owe more than your home is worth. This does not affect your monthly payment, but it means you cannot borrow more or refinance easily.

Can I close a home equity loan and a new mortgage on the same day?

Yes, but it requires coordination. Both lenders must agree to the timing, and you will sign closing documents for both loans in one session. The home equity lender funds first, then the new mortgage lender funds. This is possible but not automatic—discuss it with both lenders early.

What if I cannot afford both the home equity payment and the new mortgage?

You will not be approved for the new mortgage. Lenders calculate your debt-to-income ratio including the home equity payment. If adding it pushes you over 43 percent DTI, they will deny the new mortgage or approve you for less. Use a mortgage calculator to test different scenarios before applying.

Do I have to use a home equity loan, or can I just use savings?

You can use savings, gifts, or any source of funds for a down payment. Home equity is one option among many. If you have savings available, using them avoids a second monthly payment and the risk of foreclosure on your current home.