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Obtain a Home Loan to Buy a Second Vacation Home

How to Obtain Financing for a Vacation Home

Owning a second home can be a sound financial investment. It can also provide a welcomed retreat for the family when you need a break from the city. However, financing a secondary residence is often more complicated than first-time buyers expect.

Lenders have stricter financing requirements when it comes to the purchase of a second home or vacation property, and that can make it more difficult for potential buyers to qualify for a mortgage.

Beyond the questions of financing, there are also tax implications to be considered as well as a variety of ancillary costs that are unique to the purchase and ownership of a secondary residence.

What Qualifies as a Second Home?

First-time buyers often confuse the idea of vacation homes with investment properties. But for the purposes of financing, the two terms are not interchangeable.

By definition, a secondary residence is a home that the buyer intends to occupy at various times throughout the year. It may be a vacation cabin in the woods, or even a condo in the city, but for at least 30 days during the year it is owner-occupied.

To qualify as a second home a property must meet the following criteria:

  • Property must be owner occupied for no less than 30 days out of the year
  • Property must be a single-unit dwelling
  • Property must be kept suitable for year-round occupancy
  • Property must be exclusively under the owner's control and not subject to rental, time-share or property management agreements

How Does a Primary Mortgage Differ from a Secondary Mortgage?

Financing a second home is not totally dissimilar to financing your primary residence.

For the lender, it is all about assessing your risk as a borrower. The same criteria apply whether the home will be a primary or secondary residence. That being said, while the basic criteria in review are the same, the outcome can often be very different for a secondary effort.

For your convenience here is a list of lenders offering competitive rates in your local area.

Lenders tend to be more conservative when it comes to financing second homes, so they expect borrowers to meet or exceed some specific financial thresholds before they will consider approving the mortgage application.

  • Credit Score – Buyers looking to finance a second home need to have a particularly strong credit score for their mortgage to be approved at a favorable rate. As a general rule 25 – 50 points above the standard needed to secure a first home mortgage is the standard here.
  • Down Payments – Depending on the lender, financing a second home typically requires a higher down payment from the buyer. Unlike a first home mortgage where the buyer can often get financed with as little as 3% down, lenders will want to see at minimum 10% down on a secondary or vacation property. Higher still, if the applicant's credit score is in dispute or damaged. If the buyer lacks the sufficient cash reserves to meet this threshold lenders will sometimes allow borrowers to use the equity in their primary residence to make up the shortfall.
  • Income Stability – Buying a second home means assuming a second mortgage, and that puts the buyer in a higher risk category. Lenders will be more particular about the applicant's work history and will expect the buyer to show an income consistent with the increased burden of a second mortgage.
  • Cash Reserves – Again, a second mortgage means greater risk for the lender and they will expect more extensive cash reserves be available to offset that risk. In the case of a secondary residence mortgage borrowers should expect to have 3 – 5 months of cash reserves on hand to secure their loan. Some lenders may require even more depending on the applicant's credit score and down payment.
  • Debt-to-Income Ratio – A homebuyer's debt-to-income ratio (DTI) is always a critical factor when applying for a mortgage, and lenders will give it even greater significance when the buyer is financing a second home. If the buyer's first home is not paid-off they will be managing two mortgages at the same time, putting an even greater strain on their income. Most lenders will want to see a combined DTI of less than 36% before approving financing for a second home purchase.

Overall, buyers should expect their banker to have much tighter lending standards when it comes to approving and underwriting a loan for a secondary residence.

Interest and Taxes on a Second Home Mortgage

Over the years, homeowners have relied on tax deductions to help reduce the real cost of purchasing a home. These same deductions were often applicable to secondary residences as well. With the adoption of the Tax Cuts and Jobs Act of 2018 new changes to the tax codes have changed the way in which primary and secondary residences are taxed. Some deductions have been eliminated while others have only been slightly altered.

If a secondary property is being used strictly as an alternate personal residence the owner can take advantage of the standard mortgage interest deduction. Under the new tax laws owners are able to deduct the interest on up to $750,000 of any qualifying home loan. To qualify for this deduction the mortgage must be classified as a secured debt.

Renting out a second home impacts the way interest and taxes are addressed. If an owner rents out their second home for 14 days or less it is still considered a personal residence and qualifies for the standard second-home mortgage deductions.

However, if the owner rents the property for more than 14 days a year and resides there for less than 10% of the total time rented to other tenants, then the home is considered a rental property and is subject to very different tax obligations.

Capital Gains and Second Homes

Taxes once again become an important consideration when homeowners decide to sell their properties. According to current tax law, homeowners can realize up to $500,000 in profit, tax-free on the sale of their primary residence.  Known as the primary-home exclusion, it cannot be applied to the sale of second home.

The standard sale of a secondary residence will result in taxes being owed on the entire profit realized from the transaction. However, there are some legal ways to maneuver around the second home capital gains tax.

If the owner adopts their second home as primary residence for at least two years before they decide to sell the property they may be able to qualify for the standard deductions. Commonly known as the ‘2/5 year rule', this exception can offer homeowners a way to sell their second homes and still avoid paying the full weight of the capital gains tax the same year.

Be sure to consult with a trusted professional before making a financial decision.

Real Estate Appreciation and Secondary Residences

Real estate has always been considered a good investment and a way to consistently build wealth. It holds true for both primary residences and working rental properties. While the real estate market is always prone to fluctuations, sound property investments tend to remain valuable assets for their owners over almost any measure of time.

However, when it comes to second homes or, more particularly, vacation properties, the playing field changes.

Location, always a watchword for real estate, takes on an even greater importance. Vacation properties are luxury real estate, so their value tends to fluctuate more than a primary residence in a desirable neighborhood. During a boom, property values can skyrocket, but those same values can plummet just as quickly during an economic downturn.

Ultimately, buyers considering a second home as an investment asset should proceed with caution. If the property is in a good location for a primary residence, or even a rental property, it has a better chance of holding or perhaps increasing its value.

If its value is instead more unpredictable due to the location, then ultimately realizing the initial costs upon selling may prove to be more difficult. Caution, is key.

Vacation Home vs. Timeshare or Airbnb?

Mauritius Sunset.

Most buyers interested in second homes are looking for the perfect vacation spot. It might be the mountains or it might be the beach, but the majority of buyers are essentially looking for a “home away from home” where they can holiday with their families.

So, does it make sense to purchase a second home or is investing in a timeshare a better option? Ultimately, it comes down to individual choice. Either option has its positives and negatives, and no easy answer will suit all buyers.

If you're looking for a real home away from home, where you set the rules and everything is always as you like it, then purchasing a vacation property is probably the better choice. As a second home the property will belong to you, and you have total control over how it's maintained and who has access.

Of course, you also have total responsibility for its upkeep as well as all expenses associated with owning and maintaining the property. Still, a second home can be a valuable asset and if natural real estate appreciation works in your favor, owning a vacation property can certainly help you to build up your personal wealth.

Night in the Mountains.

On the other hand, if you are simply looking for an occasional getaway in a relaxed resort town, a timeshare or regularly using Airbnb might be more suitable. With a timeshare you pay your annual fees and abide by the rules of the contract, and you're all set. There are fewer things to worry about and your vacation property will be ready and waiting for you and your family during your allotted time. Many timeshares offer access to a variety of connected in-network opportunities.

Of course, you'll be limited in the amount of time you can spend there, and the calendar dates may not always coincide with your family's desired plans, but it is still, much less of a financial and emotional investment than purchasing a second home.

There are other risks to consider in timeshare investments, so be sure to speak to a qualified financial advisor before making a final decision. Financially, they are usually not the best option for vacations, over time. Yet if the decision is between a timeshare and owning a second home, the timeshare can be the more attractive option for sure, for a variety of specific circumstances.

And if you want ultimate flexibility simply booking an Airbnb at your leisure when you have time off is easy - though hospitality can vary widely by property. Some homes might be in a basement without a thermostat in the winter, while others are pristine perfect stays.

Finding the Right Fit

There is much to consider before purchasing a second home or vacation property. While real estate is almost always a good investment, vacation properties are far from a sure bet.

Demand for real estate in core urban markets can remain relatively strong even through recessions because people still need to live near where they work, whereas real estate in getaway markets can be more volatile in down markets.

If you are considering the purchase as a financial investment, it is best to tread carefully and research the property fully before taking on what could be an expensive second mortgage. Be aware that a hot market today, may not remain so tomorrow.

That being said, a truly solid second home or rental property makes a very secure financial investment, especially when compared to other options.

If you are looking for a home away from home, or are perhaps considering the property as a retirement destination for your golden years, the purchase becomes even more than simply a sign of sound financial planning. Your second home could mark the location of your family's future, and inspire its own lasting memories.

The important thing as any type of investor, is to view the second mortgage with realistic expectations, and assume only you can afford. In doing so, you will open up a world of opportunity, and increase your chances of finding the right fit to grow your portfolio.

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