You’ve probably heard the terms second home, investment property, vacation home and rental property. But is there any real difference among them?
And does it even matter what you call it? Turns out there are some very big differences between second homes and investment properties, especially if you are seeking to finance them.
Both are great ways to build wealth over time by capturing the appreciation of a real asset. However, they both come with risks and expenses that should be carefully considered when making a purchase.
As with any real estate transaction, you’ll want to do your due diligence and make a smart choice for your wallet, no matter which path you choose. Here, the scoop on how a second home and investment property differ.
What is a second home?
A second home is a second property where you and your family spend time away from your primary home. You might also hear a second home referred to as a vacation property. You may rent it out for a few days a year on Airbnb or VRBO, but you primarily use it yourself.
Buying a second home makes financial sense if there’s one particular vacation spot you visit regularly. Why spend a fortune on hotels or Airbnb when you can own your own piece of paradise that will hopefully appreciate in value over time?
What is an investment property?
An investment property, meanwhile, is one that you purchase with the main intention of generating income. The investment property could be next door to your own home or it could be in another state—it doesn’t really matter. You’ll be playing the role of landlord, with long-term or short-term renters paying cash to stay in the home.
Before making an offer on an investment property, you’ll want to crunch the numbers to make sure it’s a solid investment. Similarly, consider what factors will be important to prospective tenants (like access to public transportation, good schools, parking and low crime rates).
How to finance a second home or investment property
If you need to secure a mortgage to purchase your new property, you should know that financing a second home or investment property is different from financing a primary residence. While mortgages on second homes and investment properties have some similarities, there also are some key differences.
Interest rate: You can expect to see a higher interest rate for both second homes or investment properties than for primary homes. That’s because lenders view those transactions as riskier. If you get into a tight spot with money, you’re far more likely to stop paying the mortgage for your second/investment property than for your primary home.
Qualifying: Whether you’re buying a second home or an investment property, you might need to do some extra legwork to qualify for that second loan. Your bank may require you to prove that you have healthy cash reserves (so it knows you can afford both mortgages). It’ll take a long, hard look at your overall financial situation, so be sure everything is in top order before you apply.
Down payment: Depending on your situation and the lender, you also might need to bring a larger down payment to the table for an investment property or second home, typically 15 percent to 25 percent. Again, this is because the bank wants a bigger cushion to fall back on in case you default.
Rental income: If you’re buying an investment property, your lender might allow you to show that anticipated rental income will help cover the mortgage payments. Proving how much rental income the home will generate can be complicated. Prepare to pay for a specialized appraisal that takes into account comparable rents in your area.
Location: Your lender may require a second home to be 50 to 100 miles away from your primary home. An investment property, however, can be anywhere in comparison with your primary home, even next door.
Taxes: Federal income tax rules are different for vacation homes and investment properties. You typically will treat your second home just as you would your first home when it comes to taxes—if you itemize, you can deduct the mortgage interest you paid up to a certain limit.
(The rules vary if you rent out your second home for part of the year.) If you own an investment property, you can deduct the mortgage interest, plus many of the expenses that come with operating a rental business, but you also have to report your rental income.
Why it’s important to not confuse the two
It’s important not to use the terms “second home” and “investment property” interchangeably. Some people try to pass off their investment property as a second home to get more favorable financing, but you should never do this.
If you misrepresent yourself on your loan application, you could be committing mortgage fraud, which is a federal offense. Your lender’s underwriting team is aware of this possibility, and they’ll take the big picture into account when deciding what loan terms to offer you. Bottom line: Keep everything aboveboard, and you won’t have to worry about a thing.