How to Refinance a Mortgage to Buy a Second Home

Purchasing a second home might be near the top of the wish list for many people. An estimated 81% of people would rather spend money on a second property or a family vacation home than pass cash on to the next generation. Owning a second home means having easy access to a special place for bonding with your loved ones, but it can also be a wise investment for building wealth and generating passive income to support early retirement. 

Funding your second home can be tough, but if you have an existing mortgage and have enough equity, you can refinance a mortgage to buy a second home. Before you tap into your home equity to buy a second home, you should understand how refinancing works.

Understanding How a Cash-Out Refinance to Buy a Second Home Works

Cash-out refinancing is the process of taking out a new mortgage that is enough to cover your existing mortgage and the cash you want to borrow against your equity. The total loan you can get depends on how much equity you have in your home.

Determining Your Home Equity

Your home equity refers to the part of the property that you own. If you have a fully paid property, you have 100% equity. If you have a mortgage, your equity will be the market or appraised value of the property less any mortgage against the property.

If you have an existing mortgage of $100,000 on a home worth $250,000, your home equity is $150,000. You can use the $150,000 equity as collateral.

Lenders usually require borrowers to leave at least 20% equity of the property value. If the property value is $250,000 minus 20% then $50,000 can’t be used as collateral for the loan. This means that you can only borrow up to $200,000 ($250,000 less $50,000) against the property.

Cash-Out Refinancing Example

For a property valued at $250,000, you can only borrow up to $200,000. If you get approved for this loan, proceeds will go first to paying off your mortgage of $100,000. You will receive the difference of $100,000 as a lump sum payment which could go towards purchasing your second home.

Each lender may have their own rules on how much you can borrow against the equity of your property. In some cases, you can borrow more based on your home equity. The total amount you will receive after the transaction may also be lower because of closing costs and other fees.

Pros and Cons of Refinancing for a Second Home

Cash-out refinancing is a viable way to buy a new home with affordable financing. However, buyers should weigh the pros and cons before moving forward to applying for a loan.

Pros 

• Quick access to cash:  Access large sums quickly to buy a second home. Refinancing has no restrictions on how borrowers can use lump sum payments.
• Lower interest rates: Refinancing can help you secure a loan with lower interest rates compared to your existing mortgage. Rates may also be lower than home equity loans, HELOC or a mortgage for a second property.
• Consolidate mortgage payments: Refinancing lets you consolidate your mortgages into a single payment. You also have the flexibility to choose between a variable-rate or fixed-rate loan.
• More options on repayment terms: Refinancing lets you choose repayment terms that fit your needs. Terms can be longer or shorter term depending on your financial strategy.

Cons

• Greater risk of foreclosure: Since you're taking additional debt against the property, the risk of losing your home can be higher if you default on loan payments.
• More debt: If you’re refinancing the purchase of your second home, your total debt will increase. Your total home equity will also be lower. 
• Higher interest rates than traditional loans: While refinancing allows you to take advantage of reduced rates compared to mortgaging a second property, the interest rates can be higher than what you would get for a traditional mortgage.
• Closing costs for the new mortgage: When you refinance your mortgage, you may have to pay the appraisal fee, closing costs and private mortgage insurance (PMI).

Requirements for Cash-Out Refinancing

Many financial institutions — banks, credit unions, mortgage companies —- offer cash-out refinancing. Actual requirements vary for each lender but usually include the following.

Sufficient Equity in Primary Residence

You need equity to be eligible for cash-out refinancing. You may have to provide an appraisal to determine the market value of the property. 

Most lenders allow a maximum loan-to-value (LTV) ratio of 80%. If you are eligible, you may qualify for 100% refinancing from the Veterans Administration.

Good Credit Score

Lenders require a good credit score of at least 640 to apply for cash-out refinancing. However, more lenders prefer customers with a credit score of 680 to 700 or more. For FHA loans, the credit score requirements should ideally be between 680 and 700.

Debt-to-Income Ratio

Borrowers should have a reasonable debt-to-income (DTI) ratio to qualify for cash-out refinancing. You can calculate this ratio by dividing your monthly debt by your monthly income. If you owe $5,000 per month and your monthly income is $20,000, your debt-to-income ratio is 25%. Aim for a DTI ratio of 40% or less.

Proof of Income and Assets

Lenders assess if you have the financial capacity to take out a loan. You can prove this by submitting proof of employment/income and a list of your assets such as:

• W-2s or 1099s
• Tax returns
• Bank statements
• Employment certificate

Fees

Cash-out refinancing creates a new loan, so you may have to pay fees and closing costs. Fees range from 2-5% of the loan value. You may also have to pay PMI if the loan exceeds 80% LTV. PMI could cost 0.55% to 2.25% of your loan.

How to Apply for a Cash-Out Refinance to Buy a Second Home

If you are eligible based on the requirements above, it's time to move on to the next step — applying for refinancing. Before applying, research — know your LTV, estimate property value and determine the money you need for the second home.

Assuming you already have a lender, here are the next steps in the process:

• Request for a list of requirements from your lender.
• Prepare all the paperwork based on the list you received from the lender.
• Apply for refinancing and submit all the requirements.
• Request for an appraisal to determine the property value.
• Close on your new mortgage.

Don't forget to shop for the best terms and rates for cash-out refinancing if you are still looking for a lender.

Compare the Best Mortgage Refinance Companies from Benzinga’s Top Lenders

Cash-out refinancing can provide a low-cost loan to buy a second home. Here are the best lenders to consider if you believe cash-out refinancing is the right financing option.

Other Ways to Buy a Second Home

Cash-out refinancing is not the only way to tap into your home equity. Check out the options below if you are looking for alternatives. 

Home Equity Loan

A home equity loan is a loan, usually with a fixed interest rate and fixed payments, that uses your home as collateral. Like cash-out refinancing, you can only borrow up to 80% LTV. With a home equity loan, you are applying for a second loan against the property. As a result, you have to make two payments —- mortgage payments and the home equity loan payment.

Home Equity Line of Credit (HELOC)

Like cash-out refinancing, a HELOC uses your primary residence as collateral. Since it is a line of credit, you can pull out funds against your credit line anytime. HELOC has a variable interest rate — when interest rates increase, the loan becomes more expensive.

Refinancing Could be the Best Way to Buy a Second Home

Purchasing a second property could be attractive but expensive. Since mortgage companies charge higher interest rates for second-home mortgages, consider refinancing your mortgage. If you have enough equity, you can cash out your equity and buy a second home through refinancing. You can also take advantage of lower interest rates and better loan terms compared to your current mortgage. Like any financial decision, don't take cash-out refinancing lightly. Do your research, consult a financial advisor if you need to and weigh the pros and cons.

Frequently Asked Questions