Tapping your equity to buy a second home

August 16, 2013: 6:15 AM ET
NEW YORK (CNNMoney)

Should I use my home's equity to purchase another property? -- Anonymous

With housing markets heating up and interest rates still low, it can be a great time to invest in real estate. But if you don't have a lot of extra cash on hand, how do you pay for it?

There are the usual methods, like financing the purchase with a mortgage or selling some stocks and bonds, and the usually bad ideas, like taking money out of your IRA or a loan from your 401(k), but some second home buyers have another option: the equity they've built up in their home.

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Home equity is the difference between what a person owes on their mortgage and their home's market value. For example, someone who owes $200,000 on a home that is worth $300,000 has $100,000 in home equity.

As home prices rise nationwide, so too does the value of your home's equity. That value can be monetized through a home equity loan, home equity line of credit or what is called a cash-out refinance. (That's when you take out a new loan with a higher balance that pays off your existing mortgage and then you can use the remaining balance toward other things, like a second home.)

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Unlocking some of your home's value to pay for a second home has its advantages -- but it has some big drawbacks too, says Greg McBride, a senior financial analyst for Bankrate.com.

Lenders tend to give more favorable terms to those who tap their home's equity to pay for a second home because they have more skin in the game.

Buyers who take out a separate mortgage on a second home are more likely to stop making payments if they run into financial trouble and default. To offset the increased risk, banks charge higher rates and require larger downpayments of these borrowers. But those who use their primary home's equity will work harder to pay off the loan and are much less prone to miss payments, said McBride.

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The costs of borrowing, especially on home equity loans, can be lower as well, since these loans don't involve paying for title searches or insurance and other transactional costs of new mortgages.

But there are some negatives. By tapping your home's equity you'll be increasing your monthly mortgage payments and increasing the risk of losing your primary home to foreclosure.

Also, by buying another home you're tying up a lot of your money into one type of asset, said McBride. "You're putting a lot of eggs in the real estate basket. wise portfolio management says that's not prudent," he said.