The summer vacation season brings joy to many people, but for some, the longing for a year-round second home brings a touch of melancholy. If you are one of those people who would love to own a place for weekend getaways and long lazy vacations in every season, the first consideration should be how to pay for that luxury. (To determine whether buying a second home is right for you, read Vacation Home Or Income-Producing Investment?)
Not all vacation homes are expensive, of course, but even with a relatively affordable second home you need to make sure your budget can handle the extra monthly payments for the mortgage principal and interest, property taxes, homeowners insurance and any homeowners association dues. Remember to leave room in your budget for routine maintenance, utility bills and the possibility of a major repair.
How To Afford A Second Home
Financing Options for a Vacation Home
For many home purchasers, an FHA-insured loan is the prime choice because these loans require a down payment of just 3.5% and lenders offer the loans even for borrowers with lower credit scores, down to 620 or even lower in some cases. However, second home buyers are not allowed to use FHA loans for their purchase; these loans are limited only to homes that are the borrowers' principal residence.
Option 1: Cash
If you can manage to save enough, an all-cash purchase is the easiest method to pay for a vacation home. In fact, the National Association of Realtors (NAR) survey of home buyers and sellers 36% of all buyers in 2010 paid cash for their home purchase, and 59% of all investment buyers paid cash. Vacation home buyers are included in NAR's investment buyer category because they are purchasing a home that is not a principal residence.
Option 2: Home Equity Loan
For homeowners who have substantial equity in their property, a home equity loan may be an option. However, many homeowners have lost equity due to the drop in home values in recent years, so having enough equity to purchase another home is rare. In addition, lenders are less willing to approve a home equity loan that drains too much equity from the principal residence out of concern that home values could continue to decline. Lenders assume that if the homeowners run into financial trouble, they will be more aggressive in keeping up with payments on the primary residence rather than the vacation home.
Option 3: Conventional Loan
Conventional loans for vacation homes are an option, but be prepared to make a larger down payment, pay a higher interest rate and meet tighter guidelines than you would for a mortgage on your principal residence. The minimum down payment for a vacation home is usually 20% for a mortgage guaranteed by Fannie Mae or Freddie Mac, but many lenders have raised their minimum down payment requirement to 30% or even 35% for a second home.
To qualify for a conventional loan on a second home, you will typically need to meet higher credit score standards of 725 or even 750, depending on the lender. Your monthly debt-to-income ratio needs to be strong, particularly if you are attempting to limit your down payment to 20%. All borrowers need to fully document their income and assets for a second home loan, because lenders will need to see significant cash reserves to make sure you have the resources to handle payments on two homes. (For more ideas on how to finance your property, read 4 Alternatives To A Traditional Mortgage.)
Vacation home loans often have a slightly higher interest rate than a home on a primary residence. Lenders base pricing on risk and they typically feel that the borrowers are more likely to default on a vacation home loan than the mortgage on their principal residence. In addition, many vacation homes at beach or ski resorts are part of a condominium. Lenders in many instances require a condominium development to be 70% owner-occupied and that no more than 15% of the owners are behind on their association dues. It may be difficult to obtain financing for a vacation home in a condominium development that does not meet these requirements, or, at the very least, the lender will charge a higher interest rate to mitigate the risk.
For those who plan to rent their vacation home for extra income, not all lenders will allow the rental income to be considered for the loan qualification. Some will allow only a percentage of the rent payments as income, and others will require a documented history that the home has been consistently rented. (If you are interested in renting a vacation property, check out Tips For Renting A Vacation House.)
The Bottom Line
If you are daydreaming about buying a home at the beach or in the mountains, start saving some cash and paying down any debt, then approach a lender to review your options. (For related reading, see "Tax Breaks for Second-Home Owners")