Getting a mortgage for a vacation home
It’s nice to have a familiar place to escape to for a couple of weeks during the summer or several weekends every year. That’s why many people choose to spend their travel budgets to buy vacation homes in areas they enjoy spending their leisure time.
It is usually more challenging to obtain financing for a vacation home.
Homes designed for seasonal use may lack features that lenders insist on, such as central heating. Vacation homes also often carry several association restrictions that lenders will balk at financing. Lenders also realize that if the borrower’s financial situation changes, one of the first debts they’ll neglect is the mortgage on the vacation property.
For these reasons, lenders will typically be more strict when financing a vacation home. They will insist on higher credit scores than they do with main homes, and they almost never accept less than 20 percent down. Some even require as much as 30 percent before they will consider financing a vacation home.
Lenders will consider whether you can afford to own two properties before signing off on a second mortgage. In addition to the monthly payments, lenders may factor in the added costs of owning two homes, such as two sets of utilities and two sets of property taxes. Also, if you buy a vacation home near water, you will likely have to purchase flood insurance, which will add to the cost.
A prospective lender will also consider your monthly debt payments as a percentage of your gross monthly income. Some lenders may allow you to borrow an amount that makes your debt-to-income ratio 43 percent, while others will cap it as low as 36 percent. In most cases, the higher the ratio, the higher the interest rate you’ll pay on the vacation house loan.
Is it a vacation home or a rental?
If you plan to rent the house during the periods you won’t use it, you can use the rental income when calculating the debt-to-income ratio. However, if the number of days it’s rented out exceeds a certain number, the lender may classify it as a rental property instead. Loans for rental properties have higher interest rates and stiffer qualification requirements than vacation homes.
The IRS will also treat your vacation home differently for tax purposes if it becomes a rental property by its definition. The basic rule used to determine whether a property is strictly a vacation home or it becomes a rental is called the 14-day or 10 percent rule.
You can rent your place for up to 14 days a year and pocket the rental income without having to declare it on your tax return. If you rent out the house for more than 14 days a year, you are considered a landlord and must report the income. But you also qualify to deduct certain expenses.
If you use the property more than 14 days a year, or more than 10% of the number of days the home is rented out, whichever is longer, the house is considered your personal residence.
Using a home equity loan
If you have a considerable amount of equity in your primary residence, a home equity loan could be an option to financing a vacation home.
Lenders will typically allow you to borrow up to 80 percent of the equity in your home for any purpose. So if you own a $500,000 home with a mortgage balance of $250,000, you have $250,000 in equity. If you borrowed the full 80 percent, you could pay cash for a vacation home of up to $200,000.
One of the advantages of using a home equity loan is that it’s secured by the primary residence. From the lender’s perspective, the second home doesn’t matter since a home equity loan can be used for anything. The only factors that will matter are your income, your credit and the amount of equity you have in your primary residence.
From the lender’s perspective, a home equity loan is less risk than a mortgage on a vacation home because borrowers typically have a stronger commitment to their main homes than they do to second homes. Therefore, you should be able to obtain a lower interest rate on a home equity loan than you could on a second home.
Another benefit is that like with a regular mortgage, the interest on a home equity loan is tax deductible. If you stay within the 14-day 10 percent rule, you would be using the loan to purchase a residence for your use, and the usual cap on tax-deductible home equity loan interest would not apply.
Also, a home equity loan will typically require fewer upfront closing costs and fees than a separate second mortgage.
The main downside of this tactic is removing a large chunk of equity from your main home. But assuming you can use the amount to pay for the entire cost of the second home, you will have plenty of equity in that property.
If you don’t want to use all of your available equity to buy your vacation home, you can use some of it to make the required down payment.
Reverse mortgages are NOT eligible to use as a financing option to buy a vacation home (they are only applicable to primary residences).