Buying a second home might be your smartest move
Hotels are great, but they're certainly not
a good investment for visitors.
Second homes, on the other hand, can potentially
yield a return while providing a vacation spot over which you have 100 percent
control.
If you're tired of spending your holidays in hotels and vacation rentals, consider joining thousands of Americans who buy second homes each year.
Low mortgage rates make vacation home financing more affordable than ever. But buying a second home is not like purchasing a primary residence.
Here's what you need to know before jumping in.
Verify your second home options (Dec 13th, 2020)
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What to know about second home mortgages
It's common to get a mortgage for a second home. Over half of all second home buyers use a mortgage rather than paying cash.
But financing a second home or vacation home comes with different
rules than a primary residence. Before applying for a vacation home loan, you
should know that:
- When buying a vacation property, you'll
likely need at least two months of
reserves - Credit score requirements for a second
home are higher than for a first home - Second home loan options come with
lower rates than rental or investment property loans, but higher rates than primary residences - You may be able to defray your monthly
mortgage expenses by renting out your vacation home when you're not using it.
It might still qualify as a 'vacation' residence - You must plan to occupy the property at least part of the year
There are three main ways to finance a second home or
vacation property.
You could cover all or part of the purchase using the equity in your primary home. This is possible via a cash-out refinance or a home equity line of credit (HELOC) on your current home.
Or, you could finance the purchase by taking out a
conventional loan on the second home itself. This process would be much like
taking out a loan on your primary home, but with slightly tougher requirements.
Check your second home mortgage eligibility (Dec 13th, 2020)
Second home mortgage requirements
Second home mortgage requirements are a bit stricter than first home
loans.
Fannie Mae and Freddie Mac — the two agencies that set conforming
loan guidelines — set requirements for both the borrower and the home being
purchased.
Second
home mortgage borrower requirements
The most important requirement is that you need at least a 10% down
payment. This rule is non-negotiable.
But beyond the down payment rule, guidelines for second home
mortgages can be flexible. Borrowers may be approved with:
- A credit score of 680 or higher (typical)
- A credit score of 640-679 (with a down payment of 25% or more)
- A debt-to-income ratio up to 45%
If one area of your application is
weaker, you can often compensate for it by being strong in other areas.
For instance, if your credit score is right at 640, you may get approved by making a bigger down payment. Or, if you have a high debt-to-income ratio, you can make up for it with an excellent credit score and 12 months' cash reserves.
Thanks to this flexibility, it's possible to qualify for a second home mortgage even without perfect credit or a huge down payment.
Second
home mortgage property requirements
In addition, the property
itself needs to meet certain guidelines. It must be:
- Occupied by the owner some portion of the
year - A one-unit home (not a duplex, triplex,
or four-plex) - Suitable for year-round use
- Belonging solely to the buyer
- Not rented full-time, and is not under a
timeshare arrangement - Not operated
by a management company that has
control over occupancy
That first rule, stating you must occupy the home part time, is the
most important.
It means you're not allowed to finance a property using a second
home mortgage and rent it out full time. You yourself need to stay there for part
of the year.
If you plan to rent the home full time, it's considered an investment property — not a second home — and will be subject to higher interest rates and different loan requirements.
In addition, the home must be a
reasonable distance away from the buyer's primary residence. It also helps if
the house is in a resort community or area.
In short, the property must "feel" like a
recreational residence, not a rental property posing as one.
Down payment for a second home
You can buy a first home with just 3% down in many
cases. But it takes
at least 10% down to buy a
vacation home — and that's
if the rest of your
application is very strong (high credit score, low debts, and so on).
If you have a lower credit score or higher debt-to-income ratio, your mortgage lender may
require at least 20% down
for a second home. A down payment of 25% or higher can make it easier to
qualify for a conventional loan.
If you don't have a lot of cash on hand,
you may be able to borrow your down payment.
The National Association of REALTORS® says about a fifth of buyers tap into equity from their primary residence to make the down payment on the second home. This is possible using a cash-out refinance or a home equity line of credit.
When rates are low, a cash-out refinance could have the double
benefit of covering your second home down payment and lowering the interest
rate on your primary home loan.
What about FHA or VA loans?
The U.S. government doesn't sponsor loans for anything but
primary residences, since those loans are meant to encourage primary
homeownership. However, if your seller has a government-backed loan against the
property, you may be able to assume the
seller's loan.
Your loan of choice will probably be a
conventional (non-government) loan, such as those underwritten by standards set
out by Fannie Mae and Freddie Mac.
Assets needed
for a vacation home purchase
When you buy a vacation property, you'll
probably need reserves. Reserves are funds available to pay your mortgage if
you experience an interruption in income.
One month of reserves is equal to the amount of money it would
take to make one monthly payment on
both your primary residence and future second home.
You'll need at least two months of
reserves if you're a well-qualified wage earner, and at least six months if
you're self-employed or have any weaknesses in your file.
If you have at least 12 months' cash reserves, you may be able to
get away with a slightly lower credit score or higher debt-to-income ratio on
your second home mortgage application.
Credit score to
buy a second home
Credit score requirements are slightly
higher for second homes than for primary residences.
For example, Fannie Mae sets its minimum
FICO at 620 for primary home purchase loans. But a second home loan backed by Fannie
Mae requires a minimum credit score of 640 — and that's with a 25% down payment
and DTI below 36%.
If you make a down payment of less than 25%, you typically need a
credit score of at least 680 and low debts, or 720 with a higher debt-to-income
ratio.
Credit score requirements can also vary by lender. If you're having
trouble qualifying for a vacation home loan when you first apply, try shopping
around for a lender with more lenient requirements.
Income required
for a second home
Debt-to-income requirements depend on the size of your
down payment and your credit score.
Fannie Mae allows a DTI up to 45% with a 660 FICO and at least 25% down.
A 45% DTI simply means your total
monthly payments add up to 45% of your gross income.
For example, if you make $10,000 per
month before taxes, your total monthly debt payments could be a maximum of $4,500. That
includes your primary mortgage payments, second mortgage payments, auto loans, and
other ongoing debts.
Unlike investment properties, vacation
homes have no rental income to offset the mortgage payment. You have to qualify
with income from sources other than
the property you are purchasing.
If you're buying a multi-unit
vacation home, most lenders will treat your purchase as an investment property, whether or not
you plan to rent it out.
Second home mortgage rates
Second home loans have only slightly
higher interest rates than first home mortgage loans.
As with your main home, it pays to shop
aggressively for your best mortgage rate.
Compare offers from at least 3-5 different mortgage lenders, and
remember to look at their fees and annual percentage rate (APR) as well as the
quoted mortgage rates.
To make sure you qualify in the first place, take a look at your assets, credit, and income — like an underwriter will.
You'll have the best chance at a low second home mortgage rate if
you pay down outstanding debts and get your credit score as high as possible
ahead of time. A bigger down payment of 25% or more can help you get a lower
rate, too.
Check today’s second home mortgage rates (Dec 13th, 2020)
Other expenses
to plan for
Owning a second home comes with extra responsibility. You'll be maintaining two households, and that could cost more than you expect. So plan carefully.
Remember, affording a home is not the same as qualifying for a mortgage loan.
Mortgage underwriters only look at expenses for principal, interest, property taxes, insurance, and, if applicable, HOA dues. If these expenditures check out, they approve your loan.
You must consider travel costs, regular maintenance, repairs, utilities, furnishings, and household items. If the second home is far away, will you need to pay someone to maintain it for you?
You might be able to offset some
or even all of these costs if you
rent your home part-time. But second home mortgages require you to occupy the home at least part
of the year.
You should be clear on the amount of time you're actually allowed to rent out the property — if at all — before banking on rental income to cover your homeownership costs.
Is a rental the same as a vacation home?
Rental homes and vacation properties are financed differently.
If you can qualify for your purchase without the property generating any income, buy it as a vacation home. You'll get a better mortgage interest rate, and qualifying is more straightforward when rental income is off the table.
However, if you need to rent out your
place to afford it, your
purchase becomes an investment property rather than a second
home.
In this case, your mortgage lender will
want to see an appraisal with a comparable rental schedule. This document tells
the underwriter the property's potential income.
The lender counts 75% of the anticipated rent as income to
you, and the monthly mortgage, taxes, and insurance are added to your expenses when
calculating your debt-to-income ratio (DTI).
Investment property mortgages often require at least 20% down, because it's very difficult to get mortgage insurance for these purchases. Investment property mortgage rates can be 50 basis points (0.5%) or higher than rates for primary residences.
Can I use rental income to pay for my second home mortgage?
Owning a second home may not be as expensive
as it first appears. The reason: potential rental income.
Some homeowners defray their monthly
mortgage expense by renting out their vacation home when they're not using it.
The rise of Airbnb and similar services makes it easier for vacation home buyers to receive
occasional rental income.
This practice is allowed by most
lenders. Fannie Mae, the agency that creates rules for the majority of the
nation's mortgage loans,
updated its stance on
this issue.
While rental income can't be used to qualify for the loan, Fannie Mae now says lenders can consider a property a "second home" instead of an "investment property" even if rental income is detected.
Rental income cannot be used to qualify for a second home mortgage. But you can use rental income toward your mortgage payments once you own the home.
This is important. The rule may not
come into play when you buy, but it most certainly will if you want to refinance in the
future.
Second home mortgage rates are lower than
those for rental and investment properties. And down payment requirements for second homes are more
lenient.
Make sure the property meets all second home requirements to avoid paying higher interest rates now and on a refinance later.
Also note that, even though rental income won't affect loan
eligibility, the income has tax implications.
If you have tenants in your vacation home for more than 15 days out
of the year, you'll have to report the rent as income to the IRS.
But you may also qualify for tax savings such as the mortgage interest deduction and deductions for your expenses maintaining the home.
Three ways to finance a second home purchase
If you're thinking about buying a second
home this year, there are a few different ways you can fund the purchase.
You may not even have to take a loan out
on the second home.
These are the most popular methods of
making a down payment — or paying cash — for a second home.
1. Use a
cash-out refinance on your primary home
Home values are rising across the country, with sales prices hitting record highs in some areas.
Many homeowners have built substantial equity in their primary or rental residence in just the past few years. They can tap into this equity via a cash-out refinance.
For example, say a homeowner
owes $100,000 on their mortgage,
but their home is now
valued at $200,000 due to appreciation. They could withdraw some of the equity by refinancing into a bigger loan
and taking the difference in cash.
In this case, the borrower would have
access to a substantial down payment on a second home:
- New loan amount: $160,000
- Current mortgage: $100,000
- Closing costs: $3,000
- Available
cash: $57,000
Borrowers who have good credit could
borrow up to 80% of their
home's current value with a conforming loan. Other loan types allow an even higher
percentage.
For example, veterans may have access to 100 percent of their equity if they use a VA cash-out loan.
Today's low mortgage rates may allow borrowers to drop
their rate while taking a cash-out refinance. Some homeowners could even
come out with a similar payment on a bigger loan amount thanks to a lower
interest rate.
Cash-out refinancing can be a good way to
liquidate your home equity and use it to afford that vacation home you've had your eye
on.
But before you take this step, be sure you can afford the
larger monthly payment on your first home.
Also consider the financial obligations
associated with second home ownership, including property taxes, insurance premiums and deductibles, and ongoing
maintenance costs.
For many, taking out a bigger loan on real estate they already own is the most economical way to buy a second home.
Verify your options on a second home (Dec 13th, 2020)
2. Open a HELOC on your current home
According to NAR's annual vacation home buyer survey, a home equity line of credit (HELOC) on a primary residence is a favorite funding source for second home buyers.
If you have enough equity in your home
right now, then you could simply
take out a line of credit and buy your second home outright or
use the funds to make a down payment.
This option would eliminate the need to
refinance your current mortgage. You would keep your first mortgage intact and
add another loan with different terms.
You might want a HELOC if you have
recently refinanced into a very low rate. Opening a line of credit does not
affect your first mortgage.
You might want a HELOC if you have recently refinanced into a very low rate on your first mortgage.
Typically, applicants need good to excellent credit for a HELOC. But these second mortgages come with
some interesting perks.
Once approved, cash generated from the loan is yours to
use as you wish. You can
use the credit available, pay it back, and then tap it again throughout your
HELOC's loan term.
Plus, you may be able to circumvent the higher closing costs
you'd have to pay
by taking out a new primary mortgage.
You usually have the choice of a HELOC which has a variable rate, or a home equity loan that has a fixed rate.
The fixed option comes with a slightly higher rate but has better payment stability built-in, making it a good choice for some second home buyers.
3. Get a loan on the second home itself
As discussed above, another option is to get a loan via conventional financing.
Current rules allow for down payments as low as 10%, and credit eligibility guidelines
can be lenient depending on the lender.
Don't think you can qualify to buy a second home? You might be surprised.
What are today's second home mortgage rates?
Mortgage rates are ultra-low across the
board, so vacation home loans are cheap right now as well.
To make home buying even more affordable, shop around for rates by
calling at least three mortgage lenders. Most, if not all, lenders who offer
primary residence loans also offer second home mortgages.
Make sure your loan officer knows you'd like to finance your
purchase as a vacation home and not an investment property.
Get a quote for your vacation home
purchase and be sure to shop around to get your best rate.
Verify your new rate (Dec 13th, 2020)
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