Take a break from daydreaming about leisurely vacations in your Hawaii condo, and start researching your options for financing that second home.

You have it all planned out. Relaxed mornings in your vacation home-sipping hot coffee on the patio, listening to the waves break-will quietly evolve into afternoons of golf or tennis. It will be your retreat, a place with no work, no stress and...no mortgage payment?

If the idea of buying a second home has overtaken your thoughts before you've had time to consider the practicalities, don't worry. Despite the troubles in the mortgage industry, there are several options when it comes to financing a second home.

Tapping first to enjoy second

The easiest option for second home financing is to borrow against the equity in your primary home. You could do this by refinancing your first mortgage for a larger amount, by taking out a home equity loan (or second mortgage), or by tapping a home equity line of credit (HELOC). Each of these, however, carries its own cost and tax consequences for you to evaluate.

  • Cost. Borrowing more money against your first home will be less expensive than borrowing money against the new home. But you also have to compare the interest rate that you're paying on that first mortgage to current market available rates. If your first mortgage rate is lower than market rates, a refinance doesn't make sense.

    Take a look at the going rates for second mortgages, and compare these to the rates associated with taking out a first mortgage on the vacation home.

    Regarding a home equity loan versus a HELOC, the fixed-rate loan may have a higher rate at the start, but offers less risk in the long run.
  • Taxes. Only the interest associated with the first $100,000 of home equity debt is tax deductible. Also, you might be considering using home equity debt at first, and then replacing that debt with a new loan later. If you want the interest on the new mortgage to be tax-deductible, you have to fund it within 90 days of purchasing the property.

Funding a separate mortgage

A new mortgage on the second home will probably cost you about three-eighths of a point more than a conventional, first home mortgage. There are some tax rules to consider here, as well. Generally, the new mortgage will be tax-deductible on two conditions:

  • The home isn't rented out.
  • The home is your second home and not your third (or fourth).

If you rent out the home periodically, you have to meet minimum use requirements to maintain the tax deductibility of the mortgage. Check with irs.gov or your tax advisor for further clarification on this point.

Your second home is supposed to relax you, not stress you out. Get the financing question squared away soon, so you can go back to planning your days of doing nothing at all.

Published on December 22, 2010