Purchasing a vacation getaway in the Hollywood Riviera can be a smart financial choice, especially if you plan on using it several times a year and renting it out for extra income the rest of the time. But if you need to obtain a second mortgage to buy an additional home, be prepared.
You will encounter more stringent underwriting requirements, and you also will have to provide a larger minimum down payment than on your first mortgage. Here are five things to know about buying a vacation property including the requirements, costs and process for getting another mortgage.
1. Your first home could help fund your second
Have a large amount of equity in your first home? You could get enough money to pay for most—if not all—of the cost of a second home. Two options include:
• A cash-out refinance
This is when you replace your current mortgage with a new, larger mortgage so you can access cash via your home equity. A cash-out refinance is taken out on a primary home mortgage, so you could borrow more money and at a lower rate than if you took out a secondary mortgage loan—such as a home-equity loan or home equity line of credit (HELOC). A cash-out refinance could allow you to get a loan of up to 80 percent to 85 percent of your first home’s value. Note: Watch for closing costs, which can lower the amount of cash you receive by several thousands of dollars.
• A home-equity loan (or HELOC)
With these loans, the equity in your primary home is used as collateral to obtain money as a lump sum loan or credit line that can be used over time. A home-equity loan enables you to receive the money all at once and pay a fixed interest rate, while HELOCs have variable rates and are more often used for various expenses over time. Both options might allow you to take out a higher loan-to-value (maybe 85 percent to 90 percent) than you would for a cash out refinance. Want to pay for the second home in cash? A combination of refinancing funds—plus savings, a personal loan or a 401(k) loan—could provide all you need. If that’s not enough, however, a second home mortgage probably will be the best option.
2. Be ready to define how you will use the home
If your current home will continue to serve as your primary residence, you will need to tell the mortgage lender how you plan to use the additional home. Lending underwriters must follow the guidelines of Fannie Mae and Freddie Mac, the government-sponsored enterprises that back about 70 percent of single-family home mortgages. Lenders consider properties that are used as second homes—rather than as investment properties—to be less risky, which means you may be able to qualify for a lower interest rate.
Before you can classify a vacation home as a second home for mortgage purposes, you have to meet certain lender requirements: You must live in the home at least part of the year and keep it for your personal use and enjoyment at least half the year; the home can function as a second home and is only one unit; you can provide short-term rentals, but the home cannot be under the control of a property management company; and it can’t be located too close to your primary residence, which might disqualify it from being reasonably considered a vacation home.
3. Underwriting is more difficult
Since you already have one mortgage, you can expect the underwriting process to be even tougher when you’re trying to obtain a second mortgage. For example, lenders may ask for larger down payments and charge higher interest rates. Here’s a rundown of how underwriting is different for a second mortgage:
• Credit score – Lenders will examine your credit score to make sure it meets their standards, which vary. Fannie Mae set the minimum credit score of 640 for a second home as long as there is a down payment of 25 percent or more, which is higher than the 620 minimum for a primary home.
• Debt-to-income ratio – Borrowers seeking a mortgage typically are required to have a maximum debt-to-income level of about 43 percent. But it’s much more difficult to meet that standard if you already have a primary home mortgage and other debts. If you want to rent out the second home, you can see if the lender will include that income in the mortgage underwriting.
• Higher down payment – While the down payment on a conventional loan for a primary residence can be as low as 3 percent, some lenders require 20 percent or more for second homes. A National Association of Realtors survey found that buyers who finance a second home typically put down 20 percent. Borrowing equity from your primary residence could be the perfect way to fund a down payment large enough to avoid mortgage insurance (or PMI) costs.
4. There are lots of added costs
Although you might be picturing warm sunsets on the beach when you’re ready to purchase a vacation home, you should factor in these costs before your dreams materialize:
• Insurance – You likely will have to pay more for home insurance due to the location of your house—think flood zones and areas with high wildfire risk. The cost also could be higher if you’re only there part-time or have renters. You may be able to combine some of your policy with the one on your primary residence, such as for liability coverage. However, you might not get as much coverage on the second home’s policy since you’re at the second home only part-time. The insurance company also might ask you to specify which situations—known as “known perils”—would be covered.
• Furnishings – If the home doesn’t come with essential furniture and appliances, you’ll have to spring for these yourself. You also might need to invest in decorations, bedroom and bath fixtures, and kitchen items.
• Maintenance – All homes require some type of maintenance, whether it be including lawn care, or roof, driveway and patio/deck repair and replacement. Consider these items when evaluating your expected start-up costs, the monthly budget and long-term expense planning.
• Utilities – Electricity, water and other utilities are a regular monthly cost.
• Taxes – Remember that taxes also will increase your costs.
5. You’ll need to conduct research and get advice
Many factors come into play when it comes to vacation home being a solid investment or a financial disaster. That’s why you’ll want to be sure and ask yourself, your family and advisers (like financial and tax experts) these questions:
• Will you use the home enough to make it worth the purchase?
• Is it less expensive to stay at a nearby hotel or rental home rather than buying a home for your vacations?
• If your employer is going to allow remote working, do you really need a second home for business purposes?
• Is your income level enough to support two mortgages for another five, 10, 20 years or more?
• Can you handle the second home mortgage payments, along with other major expenses or debts—such as college education, auto purchases or major home repairs—that may arise?
• What are the start-up costs for the new home—such as furnishings and upgrades—as well as the ongoing costs, including maintenance, major repairs and travel to and from the house?
• Are there any tax breaks you can get from owning a second home?