Mortgages for a Vacation Home
Vacation homes come in all shapes and sizes. A quiet cottage in the mountain where you can escape to be by yourself or spend quiet time with a significant other. Or a beachfront property that’s perfect for crowded family reunions.
A vacation home is certainly a luxury, and it’s one that’s becoming less popular as home prices rise and inventory shrinks in popular vacation areas. However, there are ways to make a dream of buying a second home a reality.
About 60 to 70 percent of second homes are purchased with a mortgage, according to the National Association of Realtors. Second mortgages generally require a higher down-payment requirement than mortgages on a primary residence. To finance the purchase, you could tap the equity that you’ve built in your home and take out a home equity line of credit (HELOC) or home equity loan (HEL) or use a cash-out refinance. Another option is to team up with a group of friends or family members to buy a vacation home together and split the upfront and ongoing expenses.
If you’re up for the extra work that comes with managing a rental property, you could even turn your vacation home into a source of income. But first things first, you’ve got to figure out how you’re going to buy the home.
How to qualify for a second mortgage
Mortgage lenders will consider many of the same factors when underwriting a mortgage for a second home as they would for a first mortgage. Your loan-to-value ratio (LTV), can also impact your eligibility and terms.
The requirements for a mortgage on a vacation home may be a little more strict than for a mortgage on a primary residence. That makes sense. When homeowners run into financial trouble, they may be more likely to make the mortgage payment on the home where they live than on a vacation home that they only occasionally visit.
One example is you could have to put at least 10 percent down, or 20 to 30 percent if your DTI or credit isn’t top notch. In comparison, a mortgage on a primary residence may require 5 percent down or less.
As with a primary residence mortgage, putting down at least 20 percent could be a good idea even if you aren’t required to. Doing so allows you to avoid buying private mortgage insurance (PMI), insurance that protects the lender but that you have to pay for each month.
A larger down payment could also help you secure a lower interest rate on your loan and may lower your monthly payments, which will increase your DTI.
Fannie Mae lenders will consider your DTI inclusive of your new mortgage payments and may only approve a loan if your DTI is 36 percent or lower. Although, you could get approved with a DTI up to 45 percent depending on your DTI, LTV, and credit. You’ll also need to have at least enough cash reserves to cover between two and 12 months’ worth of debt payments.
The minimum FICO credit score requirements also may be around 640 to 700 for a second home. By contrast, you may be able to qualify for a Fannie Mae mortgage to buy your primary residence with a credit score of 620 or lower.
How to finance your down payment
Some people save up enough money to make a down payment or buy a vacation home with cash. However, most people take out a mortgage. If you’re going that route, you’ll have several options to consider.
You may be able to choose from different terms, such as a 15- or 30-year mortgage and between a fixed or variable interest rate. As with any large purchase, shopping for mortgage lenders could help you secure the best terms and rates.
Home equity line of credit (HELOC). Some buyers tap the equity in their primary home by taking out a HELOC or HEL and using the money for a down payment or to pay for the second home outright.
HELOCs let you borrow against your home as you need the money, which could be a good option if you foresee paying for renovations or improvements on your new home. However, they also often have a variable interest rate, which might arise in the future. With an HEL you can get a lump-sum payout with a fixed interest rate, which could make it easier to forward-plan your finances.
Cash-out refinance. Another option would be a cash-out refinance. In this case, you refinance your home and ask for extra money to use as the down payment on a second home. “In the current interest-rate environment, I would probably recommend customers looking into refinancing their first mortgage and utilizing that equity for a down payment,” says David Hosterman, a branch manager for Castle and Cooke Mortgage, LLC in Denver, Colo.
A cash-out refinance could be an especially good option if you qualify for a lower interest rate. When that’s the case, your monthly payments could stay the same even though your principal loan amount increases.
Getting a mortgage for a second home vs. an investment property
You may want to live in your second home for several months out of the year, or you might be planning to visit just a few times each year. Rather than having the home sit empty the rest of the time, some owners rent out their properties and turn their vacation home into an extra income stream.
While making money from your second home can be appealing, renting the home out could result in mortgage lenders classifying it as an investment property instead of a second home. This could impact your loan terms and ability to qualify for a mortgage.
“For instance, most lenders will want about 20 percent down to qualify for an investment property versus 10 percent for a second home,” says Hosterman. “Furthermore, interest rates are generally higher on investment property loans versus second home loans.”
However, there is an upside, Hosterman notes: “If you are buying a home for a rental property, you can generally use up to 75 percent of your projected rental income as income to qualify for the loan.”
To figure out how much that might be, Hosterman recommends asking your appraiser to include estimated rental rates based on comparable rental properties in the area.
Even if you don’t rent out the second home, a lender may consider it an investment property if it’s within 50 miles of your primary residence.
If you’re buying a condo in an up-and-coming part of town that’s not near any of your personal relations, that may also be an indication that your intent is to make money from renting or flipping the home, rather than treating it as a second home.
Using your second home for rental income
There may be a middle ground for those who want to make some rental income but don’t want to pay a higher interest rate or make a larger down payment for an investment property mortgage. Some lenders let you rent out a second home for part of the year as long as you live in the house more than 10 percent of the time that it’s available for rent.
However, there could also be tax implications to renting out a second home. If you rent out the home for 14 days or fewer each year, the income may be tax-free. But rent it for 15 days or more and you’ll have to report the rental income when you file your tax return.
When you’re renting it out for over 14 days, you may also be able to deduct expenses related to renting, such as advertising or property management. A portion of your home insurance premiums, property taxes, utility bills, and depreciation may also be deductible.
Working out the of renting a second home can be difficult. But don’t let that scare you off, the income from renting the home could help offset your mortgage payments. You could also consult with a tax professional, who can help you understand the details and strategize the best approach.
Buying a vacation home with family or friends
It’s not uncommon for groups to team up and buy a vacation home in a desirable location. For some, splitting the cost with friends or family is the only way to make a second home affordable.
You’ll be splitting the down payment and share in the ongoing maintenance, utility, tax and repair expenses. Plus, you’ll all be able to vacation together, or take turns and each enjoy some relaxation on your own.
Working out the details of the arrangement is an important first step. Who gets to use the home when, the expectations for cleanliness, what happens when someone wants to renovate, and other semi-personal matters may make or break a deal regardless of the finances.
You may also want to work out some of the money-related details early on. What happens if one person, or everyone, wants to sell the home? Or, what happens if one of the parties isn’t able to afford their portion of a monthly payment or necessary repair? As the co-owner of a property, you could have a legal responsibility for the entire mortgage payment, and a late payment might hurt your credit even if you paid your share.
Hiring a real estate attorney to put the details down on an official document could be a worthwhile investment. Having a contract that everyone agrees to can help you work out potential issues before they blow up into major problems.
You also want advice on what type of arrangement best suits your situation. One option may be to own the property as a tenancy in common (TIC), which allows co-owners to have a legal right to the home’s title and passes an owner’s share on to his or her estate upon death (as opposed to the share being split by the other owners).
Another option is to create a limited liability company (LLC) with your friends or family members and have the LLC buy the home. With either a TIC or LLC, you can split the ownership based on each party’s contribution; it doesn’t need to be even. However, an LLC could offer some benefits over a TIC, such as shielding the owners’ personal assets if there’s a lawsuit due to someone injuring themselves on the property.
Getting a mortgage for a vacation home with family or friends
Filling out a joint mortgage application may not be all that different to applying for a mortgage on your own or with a spouse. And, as with buying a home with a spouse, the co-buyers’ credit, income and debts may all be important factors in whether you’ll qualify and what terms you’ll be offered.
Hosterman says that when you apply for a mortgage with friends or family, the lender uses the lowest middle credit score as the qualifying score. (Each applicant could have three credit scores, each one associated with their credit reports from Equifax, Experian and TransUnion.)
He also says that “all of the borrowers’ debt will be taken into account for qualifying ratios, including housing payments.” As with taking out a mortgage for a second home on your own, the eligibility requirements may be a little stricter for a vacation property even if it’s bought by a group of people.
But if buying a home with friends or family members is what you want, and it helps put the home within your reach, the arrangement can work out well for everyone.