(Updated January 2015)
Before shopping for your second home, consider how you'll pay for it so that it doesn't become a burden. Using a home equity loan on your primary residence is often the smartest path, because you can use otherwise untapped value in your home to your advantage without raiding assets such as bank accounts, stocks, or other savings.
Here are four ideas to help guide your decision:
1. Leverage equity
If you've accumulated equity in your home, don't just sit on it. Put it to work by borrowing against it while home equity loan rates are still attractively priced.
There are several advantages to this approach. First, it simplifies the process of buying the second home. Vacation properties in particular can often be difficult to qualify for a mortgage on their own, so financing the purchase with a home equity loan on your primary residence eliminates that problem. If you're thinking of using it as an income property, at least part of the time, financing it through home equity borrowing means you don't have to worry about documenting potential rent income to justify the loan.
Banks typically charge higher interest rates on home equity loans than they do on conventional mortgages, but that's at least partially offset by the fact that they also charge higher rates on second homes and even higher ones on those that are deemed to be investment properties. And with a home equity loan, you avoid many closing costs and still may be eligible for tax deductions of interest and other expenses.
You can also use a home equity line of credit (HELOC), which allows you to borrow money as needed and may be useful if you plan to make improvements to the property over time. Another option would be a cash-out refinance of your primary residence, which would likely give you the lowest interest rate of the various options, as well as the convenience of a single mortgage payment each month.
2. Buy property conveniently located
Buy a second home that you'll definitely use, one that's in an area you enjoy but not one so far away that you'll never visit it. Location becomes especially important if you use the property as a rental for extra income, because it will be easier to check on tenants and perform routine maintenance.
If you buy a second home within 50 miles of your primary residence, lenders will treat it as an investment property regardless of whether you plan to use it that way or not. So if you're not using a home equity loan to fund the purchase, as described above, you'll want to find one at least that far away.
Consider too, the type of lifestyle you want at your second home. A condo at a resort can offer access to an active social life with many of the routine maintenance needs taken care of, but may not provide the atmosphere you seek. A cabin in the woods or on a lake may offer peace and solitude, but could also require that you spend much of your getaway time on maintenance.
3. Consider a fixer-upper
Rather than buying someone else's idea of a dream vacation home, consider creating your own. A less-than-perfect property can quickly pay for itself if you use home improvement loans to update it, and you'll have the satisfaction of remodeling or upgrading your second home to suit yourself.
If you go this route, be sure to have a thorough professional inspection of the property, beyond what's called for in the usual purchase inspection. You want a good idea of what the fix-up will actually cost and what it will actually involve. Check the zoning and association rules as well. Some associations have strict rules about what you can and cannot do in terms of altering the appearance of old cottages, or there may environmental restrictions on new construction, particularly in dune areas.
4. Mix business with pleasure
Many investors combine their use of a second home as a vacation getaway with an occasional lease or rental. Not only will you make money by leasing, you'll save money by not paying for lodging at vacation time.
The IRS considers a vacation or second home an investment property if you use it for less than 14 days a year or 10 percent of the time it is occupied, whichever is less. That means you can deduct many of the costs of operation, including mortgage interest and maintenance. You can still deduct some costs if you only rent it out part of the year, but on a pro-rated basis.
If you act now, while the buyer's market is still hot and overextended sellers are desperate, you can possibly acquire an undervalued second home at a discounted price. By using a home equity loan to finance it, you'll leverage your money in two ways. The existing value in your primary home can help acquire a long-term investment with built-in profit (and holiday pleasure) potential.