You’ve returned from summer vacation so thrilled with where you stayed that you’re considering buying a home there.
To justify the expense, you tell yourself that vacation homes can also be used as rental properties, providing income to fund your trip when you’re not staying at the vacation home.
That may be true and will hopefully happen if you buy a second home, but before your tan and the thrill of possibly living part-time in a favorite vacation spot fades, there are some things you need to know about qualifying for a loan for a vacation home versus qualifying for a loan to buy an investment property that’s used as rental property.
Both types of property may seem the same, but to lenders there are differences that set them apart. Here are some of them:
Vacation homes cost more
Among the risks to buying a vacation home, the biggest may be that they normally cost more than investment properties. That can mean a larger loan and a bigger risk to lenders.
The median price of a vacation home in 2015 was $192,000, while the median investment home sales price was $143,500, according to the National Association of Realtors.
That extra cost for a vacation home can be OK if you’re not counting on it to provide income so you can pay the mortgage. Most vacation homebuyers aren’t treating them as investments, with a majority of people in the NAR survey saying they plan to use the home for family vacations or in retirement. Only 7 percent bought so they could generate income through renting.
Lower interest rate for vacation homes
If you don’t need rental income to afford the second home, then you’re better off buying it as a vacation home and should get a slightly lower mortgage rate than you would with an investment property.
“You’re probably going to pay a half a percent more for an investment property,” says Pete Lang, an investment specialist at Lang Capital in South Carolina.
A vacation home is a second home, and lenders have the same requirements as they would for a primary home, Lang says: Good credit, assets and income to pay the loan.
“Once you say that it’s an investment property and you’re going to rent this home out, then you’ll be paying a higher interest rate,” he says.
Proof of potential income for rental
If rental income is part of the equation in purchasing a second home, then buying an investment property requires a little more work in qualifying for a loan than a vacation home that doesn’t require rental income.
Your lender will want to see an appraisal with a rental schedule that details the potential income of the property.
Seventy-five percent of the anticipated rental income will count as income to you, leaving room for tenants who don’t pay their rent or a rental that sits empty for a few months. The monthly mortgage, taxes, insurance and any HOA dues will be added to your expenses to calculate your debt-to-income ratio, or DTI.
More income, less debt
Your DTI requirements depend on your down payment, which we’ll get to next, but you’ll likely need a higher income to qualify for a loan for a second home. The reason is simple: You’re adding another mortgage to your expenses, assuming you’re paying a mortgage on your primary home.
A vacation home won’t have rental income to offset the mortgage payment, so you’ll have to qualify with your income from somewhere else.
Fannie Mae allows a DTI of up to 45 percent with a 660 FICO and at least 25 percent down. In other words, your monthly payments add up to 45 percent of your gross income. If you make $10,000 per month before taxes, your total payments for your primary home, second home and other loans can be for up to $4,500 total.
More money down
The down payment on a home can be as low as 3 percent, but can be 10 percent for a vacation home and 20 percent or more for an investment property.
More vacation home buyers have bigger down payments than investors, according to NAR, though about an equal number paid the full price in cash.
The study found that vacation buyers who paid in cash jumped to 38 percent from 30 percent in 2014, while cash purchases by investors decreased to 39 percent from 41 percent a year ago.
Of buyers who took out a mortgage, 52 percent of vacation buyers and 44 percent of investors financed less than 70 percent of the purchase price.
Reserve assets will probably be required by a lender to buy a vacation property to pay the mortgage if you lose your job or whatever other income you have.
From two to six months of reserves may be needed, depending on how steady of a job you have.
One month of reserves is how much you’ll need to pay the mortgage on your primary and secondary homes.
Along will all of these factors, consider how often you’ll use the second home and if it’s worth the extra cost and effort.
Lang, the investment advisor, says he isn’t advising clients to buy second homes for a few simple reasons — demand is slowing among retirees, increasing taxes can make it difficult to own, and the costs of wear and tear as a rental can be high.
In addition to the extra mortgage, you’ll be paying to maintain two homes, have extra travel expenses, and may have to act as a landlord. That can be worthwhile for the tax advantages and joy of having a second home for vacations, but the headaches may outweigh the relaxation of staying in someone else’s home.