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Mortgages for a Vacation Home

Mortgage for a vacation home

A vacation home is a luxury that’s becoming less popular as home prices rise and inventory shrinks in desired areas. However, there are ways to make the dream of buying a second home a reality.

More than two-thirds of vacation homes are purchased with a mortgage, according to the latest data from the National Association of REALTORS. Financing a vacation home may involve tapping into the equity you’ve built in your main home for the down payment. Another option is to join with friends or family to buy a vacation home and split the upfront and ongoing expenses. If you’re OK with the extra work that comes with managing a rental property, you could even turn your second home into an income source.

Here is our guide to vacation home loans and what it takes to qualify.

How to qualify for a second mortgage

Some people save enough cash to make a down payment or buy a vacation home outright. However, most people borrow a mortgage. If you’re going that route, you have options.

There are different terms you can choose, such as a 15- or 30-year loan, as well as a fixed or adjustable interest rate.

Mortgage lenders will consider many of the same factors when underwriting a mortgage for a second home as they would for a first mortgage. They’re still concerned with the four C’s of qualifying for a mortgage: Capacity (to pay back the loan), capital, collateral and credit.

However, the requirements for a vacation home mortgage may be a little more strict than one for a primary residence. Homeowners may be more likely to pay the mortgage on their primary residence than on a vacation home they only occasionally visit should they run into financial trouble.

You could qualify for a mortgage on a primary residence with as little as 3% down, but you’ll need a 10% down payment or more for a second home.

If you can afford it, consider making at least a 20% down payment which then your lender may not require private mortgage insurance, which is a borrower-paid policy that protects the lender if you default on your mortgage payments. A larger down payment could also help you secure a better mortgage rate and lower monthly payments.

To qualify for a mortgage, your second home must meet the following requirements:

  • Be a one-unit property.
  • Be available and suitable for year-round use.
  • Be occupied by you, as the borrower, for some portion of the year.
  • Be controlled exclusively by you and not a property management company or timeshare arrangement.
  • Although you may rent the property throughout the year (more on this later), the property can’t be used primarily as a rental property.

Getting a mortgage on a primary home vs. a second home

Primary Home Second Home
Minimum credit score 620 640
Maximum DTI ratio 45% 45%
Minimum down payment 3% 10%
Maximum LTV ratio 97% 90%
Minimum reserves 0 2 months’ worth of mortgage payments

A quick note about credit scores: Lower minimum credit score requirements are typically reserved for borrowers with larger down payments — at least 25%. The smaller your down payment, the higher your credit score needs to be. For example, if you were planning to contribute the minimum down payment allowed on a second home (10%), your credit score would need to be 720 or higher.

Fannie Mae lenders will consider your debt-to-income (DTI) ratio, which is the percentage of your gross monthly income used to repay debt, inclusive of your new mortgage payments. The lower your DTI ratio, the better, although you could get approved with a DTI ratio up to 45%. That would depend on your credit score and loan-to-value (LTV) ratio, which is the relationship between the value of a home and the loans against it.

Lenders also want to see that you have a cushion to cover mortgage payments on your vacation home. You’ll need to have enough cash reserves equal to two months’ worth of mortgage payments. In some cases, the minimum required reserves can equal a year’s worth of payments.

investment property

Credit: Getty Images

Financing a vacation home vs. investment property

You may want to live in your second home for several months out of the year, or you may plan to visit just a few times each year. Rather than having the home sit empty, some owners choose to rent their properties, turning their vacation home into an extra income stream.

While making money from your second home can be appealing, using it as a rental might result in mortgage lenders classifying it as an investment property instead of a second home, which could impact your loan terms and ability to qualify for a mortgage.

Down payment requirements on investment properties are higher than those for second homes. The minimum allowed is 15%, but that can jump to 25% if your credit score is below 700.

Additionally, interest rates are usually higher on mortgages for investment properties — your mortgage rate can range from 0.50% to 0.875% percentage points above mortgage rates for primary residences.

The upside to financing an investment property is that mortgage lenders often use 75% of projected rental income as part of the process to determine whether you qualify for the loan.

Still, you’ll need to factor in the expenses you’ll likely incur to maintain your investment property while renting it out. You may need a property management company to handle things while you’re away, which could cost you between 8% and 12% of your home’s rental value each month.

Even if you don’t rent your second home, a lender may consider it an investment property if it’s within 50 miles of your primary residence. For example, if you’re buying a condo in the town next to yours, that could be an indication that your intent is to make money from renting or flipping the home rather than treat it as a second home.

Using your vacation 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 the larger down payment that an investment property mortgage requires. Some lenders let you rent out a second home for several days throughout the year as long as you live in the house for 14 days or 10% of the time that it’s available for rent — whichever period is longer.

However, there could be tax implications to renting out a second home depending on how often it’s used as a rental. If you rent out the home for 14 days or less each year, the income may be tax-free. But if you rent it for at least 15 days, you’ll have to report the rental income when you file your tax return.

When you’re renting it out for more than 14 days, you may also be able to deduct expenses related to renting, such as insurance and maintenance. A portion of your property taxes, utility bills and depreciation may also be deductible.

Don’t let the tax responsibilities of renting a second home scare you off since the income from renting the home could help offset your mortgage payments and other expenses. To better understand what’s at stake, reach out to a tax professional who can provide more details and strategize the best approach.

Another consideration is the upkeep of your second home while you host a limited number of renters throughout the year. A professional cleaning service could cost between $50 and $90 an hour — an expense you’ll need to budget for when setting rental rates.

How to cover your down payment

If you don’t already have the cash set aside to purchase your second home outright, it may make the most sense for you to finance your purchase. You’ll first need down payment funds.

Home equity loan or HELOC

Some homeowners tap the equity in their primary home by borrowing a home equity loan or home equity line of credit (HELOC) to cover the down payment for their second home.

A home equity loan gives you a lump-sum payout with a fixed interest rate, which could make it easier to plan your finances. With a HELOC, you can borrow against the credit line as you need the money, which could be a good option for renovations or improvements to your second home. However, HELOCs often have a variable interest rate, which could increase multiple times over the life of the credit line.

Cash-out refinance

A cash-out refinance allows you to replace your existing mortgage with a new one and ask for extra money to use as the down payment on your second home. This type of refinance could be an especially good option if you can qualify for a lower interest rate. When that’s the case, your monthly payments might stay the same even though your principal loan amount increases.

Retirement funds

Taking this route should be a last resort, but you could tap your individual retirement account (IRA) or 401(k) for down payment funds.

If you’re withdrawing funds from a Traditional IRA for your down payment, you may be subject to income taxes on the amount withdrawn, as well as a 10% early withdrawal penalty. With a Roth IRA, you may be able to avoid penalties and taxes if you withdraw the funds after five years and you’re at least 59 ½ years old.

You also have the option to borrow against your 401(k) at a maximum of $50,000 or 50% of your account balance — whichever is less. The loan, plus interest, would need to be paid back in five years. If you fail to make payments, you may have to pay income taxes on the loan amount and an additional 10% penalty.

Consult your tax professional for more information about borrowing and withdrawing from retirement funds.

Buying a vacation home with family or friends

It’s not uncommon for groups to 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 sharing in the ongoing maintenance, repair, utility and tax expenses. Plus, you’ll be able to vacation together — or enjoy some relaxation on your own.

An important first step is working out the arrangement details. Decide on who gets to use the home at which times, the expectations for cleanliness, what happens when someone wants to renovate and any other semi-personal matters that can make or break a deal regardless of the finances.

It’s also necessary to work out some of the money-related details early on. What happens if one person, or everyone, wants to sell the home? Or if one of the parties isn’t able to afford their portion of a monthly mortgage payment or a repair? As the co-owner of a property, you could have a legal responsibility for the entire mortgage payment, and a late payment can hurt your credit even if you paid your share.

Hiring a real estate attorney to put the details on an official document could be a worthwhile investment. Having a contract that everyone agrees to can also help you work out potential issues before they arise.

You’ll also want to solicit advice on the type of arrangement that best suits your situation. One option may be to own the property as a tenancy in common (TIC), which allows multiple owners to have a legal right to the home’s title and pass their share to a beneficiary or 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 because someone injured themselves on the property.

There’s also the joint tenants with rights of survivorship option, which is structured as a 50/50 split between co-owners. If one co-owner dies, the deceased owner’s share of the property automatically goes to the surviving co-owner.

Getting a vacation home mortgage with family or friends

Completing a joint mortgage application may not be all that different from applying for a mortgage on your own or with a spouse. Each applicant’s credit, income and debts are used to determine whether you’ll qualify and what terms you’ll be offered.

When you apply for a mortgage with a friend or family member, the lender considers each applicant’s credit profile. A credit report and score will be pulled from each of the three major credit reporting bureaus (Equifax, Experian and TransUnion). The lender takes the second-highest, or middle, credit score from each applicant and uses the lowest middle score among the applicants as the qualifying score.

As with financing the purchase of a second home on your own, the eligibility requirements may be a little stricter for a second/vacation home even if it’s bought by a group. But if buying a second home with friends or family members is what you want — and it helps put the goal within reach — the arrangement may work out well for everyone involved.

The bottom line

Getting a vacation home involves a significant amount of money and planning. You’ll need to consider what it costs to purchase the property, along with the ongoing expenses you’ll incur.

If you’re pursuing a group purchase, be sure everyone involved is clear on the terms of ownership and put everything in writing to help minimize future issues.

As with any large purchase, take the time to shop around for the best mortgage lender by comparing offers online.

 

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