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Getting a mortgage on a second home / vacation property

Gina Pogol
Gina PogolThe Mortgage Reports Contributor

Buying a second home might be your smartest move

Hotels are great, but they are certainly not a good investment for visitors.

Second homes, on the other hand, potentially yield a return while providing a vacation spot over which you have 100 percent control.

According to the Case-Shiller Home Price Index, home prices are up nationwide by more than 5 percent since last year. That means your vacation home might pay for your vacation.

And you skip the booking hassles.

If you’ve grown weary of spending your summer in hotels and vacation rentals, consider joining more than half-million buyers who purchase second homes each year.

Understand that buying a vacation home is not a sure-fire win. And it’s not like purchasing a primary residence. Here’s what you need to know before jumping in.

Verify your options on a second home (Oct 21st, 2018)

Understand total costs

Owning a second home comes with extra responsibility.

You’ll be maintaining two households, and that could cost more than you expect. So plan carefully.

Affording a home is not the same as qualifying for the mortgage. Mortgage underwriters only look at expenses for principal, interest, property taxes, insurance, and, if applicable, HOA dues. If these expenditures check out, they approve your loan.

You must consider travel costs, regular maintenance, repairs, utilities, furnishings and household items.

You might offset some or even all of the costs if you rent your home part-time. But not all loan programs allow you to rent out a second home. You may also be able to write off your mortgage interest and property taxes to reduce overall cost.

Verify your options on a second home (Oct 21st, 2018)

Is a rental the same as a vacation home?

Rental homes and vacation properties are financed differently.

If you can qualify for your purchase without the property generating any income, buy it as a vacation home. You’ll get a better mortgage interest rate, and qualifying is more straightforward when rental income is off the table.

However, if you need to rent out your place to afford it, it becomes an investment property, not a second home.

In this case, your lender will want to see an appraisal with a comparable rental schedule. This document tells the underwriter the property’s potential income.

The lender counts 75 percent of the anticipated rents as income to you, and the monthly mortgage, taxes and insurance are added to your expenses when calculating your debt-to-income ratio (DTI).

Investment property mortgages almost always require at least 20 percent down, because it’s very difficult to get mortgage insurance for these purchases. Investment property mortgage rates can be 50 basis points (.5 percent) or higher than rates for primary residences.

Second home down payment requirement

You can buy a primary residence with just three percent down in many cases, but it takes at least ten percent down to buy a vacation home, and that’s if your application is very strong.  Otherwise, your lender may require at least 20 percent.

If you don’t have a lot of cash on hand, you may be able to borrow your down payment. The National Association of REALTORS® says that about one-fifth of buyers tap into equity from their primary residence to make the down payment on the second home.

What about FHA or VA loans? Unfortunately, Uncle Sam has doesn’t back loans for anything but primary residences. However, if your seller has a government-backed loan against the property, you may be able to assume it.

Your loan of choice will probably be a conventional (non-government) loan, such as those underwritten by standards set out by Fannie Mae and Freddie Mac.

Verify your options on a second home (Oct 21st, 2018)

Qualifying for a second home mortgage

Vacation property loans have only slightly higher rates than do primary residence mortgages.

As with your main home, it pays to shop aggressively for your best mortgage rate.

To make sure you qualify in the first place, take a look at your assets, credit and income — like an underwriter will.

Assets needed for a vacation home purchase

When you buy a vacation property, you’ll probably need reserves. Reserves are funds available to pay your mortgage if you experience an interruption in income.

You’ll need at least two months of reserves if you’re a well-qualified wage earner, and at least six months if you’re self-employed or have any weaknesses in your file.

One month of reserves is equal to the amount of money it would take to make one months’ payment on both your primary residence and future second home.

Credit score to buy a second home

Credit score requirements are slightly higher for second homes than for primary ones.

For example, Fannie Mae sets its minimum FICO at 620 for primary home purchase loans with at least 25 percent down and 640 for vacation homes with down payments of 25 percent or more.

Income required for a second home

Debt-to-income requirements depend on the size of your down payment and credit score. For example, Fannie Mae allows a DTI up to 45 percent with a 660 FICO and at least 25 percent down.

A 45 percent DTI simply means your total monthly payments add up to 45 percent of your gross income.

For example, if you make $10,000 per month before taxes, your total payments including your primary residence, second home, auto loans, and other loans, equal $4,500.

Unlike investment properties, vacation homes have no rental income to offset the mortgage payment. You have to qualify with income coming from sources other than the property you are purchasing. If you wish to purchase a multi-unit vacation home, most lenders will treat it as an investment property, whether or not you plan to rent it out.

Verify your options on a second home (Oct 21st, 2018)

New lending rule: defray second home cost with rental income

For some, owning a vacation home may sound like something reserved for the rich and famous, but that’s not necessarily true.

Owning a second home may not be as expensive as it first appears. The reason: potential rental income.

Some homeowners defray their monthly mortgage expense by renting out their vacation home when they’re not using it.

The rise of Airbnb and similar services now makes it easier to receive occasional rental income.

This practice is even allowed by most lenders. Fannie Mae, the agency that creates rules for the majority of the nation’s loans, updated their stance recently.

While rental income can’t be used to qualify for the loan, Fannie Mae now says that lenders can consider a property a “second home” instead of an “investment property” even if rental income is detected.

This is important.

Second home mortgage rates are lower than those for rental and investment properties. And down payment requirements are more lenient. The rule may not come into play when you buy, but most certainly will if you want to refinance in the future.

Make sure the property meets all second home requirements to avoid paying higher rates now and on a refinance later.

To be an eligible second / vacation home, the property must be:

  • Occupied by the owner some portion of the year
  • A one-unit home (not a duplex, triplex, or four-plex)
  • Suitable for year-round use
  • Belonging solely to the buyer
  • Not rented full-time, and is not under a timeshare arrangement
  • Not operated by a management firm that has control over occupancy

In addition, the home must be a reasonable distance away from the buyer’s primary residence. It also helps if the house is in a resort community or area.

In short, the property must “feel” like a recreational residence, not a rental property posing as one.

Three ways to finance a second home purchase

If you’re thinking about buying a second home this year, there are a few different ways you can fund your new purchase.

You may not even have to take a loan out on the second home.

These are the most popular methods of making a downpayment — or paying cash — for a second home.

1. Use a cash-out refinance on your primary home

Home values are rising across the country.

Many homeowners have built substantial equity in their primary or rental residence in just the past few years. They can use tap into this equity via a cash-out refinance.

For example, a homeowner owes $100,000 on her mortgage, but her home is now valued at $200,000 due to appreciation. She could “extract” some of the equity by refinancing into a bigger loan and taking the difference in cash.

In this case, the borrower would have access to a substantial down payment on a second home:

  • New loan amount: $160,000
  • Current mortgage: $100,000
  • Closing costs: $3,000
  • Available cash: $57,000

Borrowers who have good credit could borrow up to 80 percent of their home’s current value with a conforming (Fannie Mae or Freddie Mac) loan. Other loan types allow an even higher percentage.

FHA loans allow 85 percent cash-out refinancing, while veterans may have access to 100 percent of their equity if they use a VA cash-out loan.

Today’s low mortgage rates allow some borrowers to drop their rate while taking a cash-out refinance. They could even come out with a similar payment on a bigger loan amount thanks to a lower interest rate.

Cash-out refinancing can be a good way to liquidate your home equity and then use it to afford that vacation home you’ve had your eye on.

Before you take this step, be sure you can afford the larger monthly payment on your primary home. Also consider the financial obligations associated with second home ownership, like taxes, insurance, and ongoing maintenance.

But for many, taking out a bigger loan on real estate they already own is the most economical way to buy a second home.

Verify your options on a second home (Oct 21st, 2018)

2. Open a HELOC on your current home

According to NAR’s annual vacation home buyer survey, a home equity line of credit (HELOC) on a primary residence is a favorite funding source for second home buyers.

If you have enough equity in your home right now, then you would simply take out a line of credit and buy your second abode outright or use the funds to pay for the down payment.

This option would eliminate the need to refinance your current mortgage. You would keep your first mortgage intact and add another loan with different terms.

You might want a HELOC if you have recently refinanced into a very low rate. Opening a line of credit does not affect your first mortgage.

Homeowners can tap into 100 percent of their home’s value with a HELOC in some cases. Many local credit unions and national banks offer high loan-to-value home equity lending. Lenders are opening up new HELOC options daily.

Typically, applicants need good to excellent credit, but HELOCs come with some interesting perks.  Once approved, cash generated from the loan is yours to use as you wish. Its interest rate is based on Prime rate, which is very low right now. So the rate may be lower than you would pay on a conventional mortgage.

Plus, you may be able to circumvent the closing costs that you’d have to pay by taking out a new primary mortgage.

You usually have the choice of a home equity line which has a variable rate, or a home equity loan that has a fixed rate. The fixed option comes with a slightly higher rate, but has better payment stability built in, making it the right choice for some second home buyers.

3. Get a loan on the second home itself

As discussed above, another option is to get a loan via conventional financing. Current rules allow for down payments as low as ten percent, and credit guidelines can be lenient, depending on the lender.

Don’t think you can qualify to buy a second home? You might be surprised.

Second home: It’s still a business deal

It is tempting to jump into a vacation home purchase, but first, weigh the benefits and costs.

Ensure that it makes long-term financial sense to buy. While there are upfront costs, a second home purchase can be a nice addition to your real estate portfolio or retirement plan.

To make ownership even more affordable, shop around for rates by calling at least three lenders. Most, if not all, lenders who offer primary residence loans also offer second home mortgages.

What are today’s second home mortgage rates?

Mortgage rates are ultra-low across the board, so vacation home loans are cheap right now as well.

Get a quote for your vacation home purchase. No social security number is required to start, and all quotes come with instant access to your live credit scores.

Verify your options on a second home (Oct 21st, 2018)