It’s fun to dream about buying a second home where one can go on vacation and get away from the daily grind of life. The great thing about a second home is that one can even pay for the upkeep by renting it out to others when not using it for themselves. However, there are many practical measures to consider before you buy that second home. Here’s what you need to know to have the best experience:
Reasons to Buy a Second Home:
People buy a second home for many reasons, such as wanting to be close to other family members or friends, taking the family on vacation, getting away from big city life, engaging in recreational activities such as skiing, boating, or gambling, or simply investing in real estate with the potential for strong appreciation. With more companies allowing work-from-home arrangements, owners might want to work from a vacation area rather than their primary residence.
Many people from northern states and Canada buy second homes in areas like Florida. They are affectionately known as “snowbirds” because they like to spend winters near the sunny beaches. Other northerners prefer to buy a cabin or lake home for hunting or fishing.
Unless you have unlimited funds to buy a second home with all cash, you must secure a home loan. However, loans for second homes differ from primary residence loans, so it’s important to find the best home loan rates for a second home.
Second Home vs. Investment Property: What’s The Difference?
The main difference between a second home and an investment property is that the owner typically lives at the second home for a few weeks to a few months a year. The home may be rented short – or long-term to other tenants for the rest of the year. An investment property is usually leased to one tenant for a year or longer. The tax requirements are also very different, with investment properties having more deductions.
The IRS dictates that a second home must be 50 miles from the primary residence. Anyone renting a second home for less than 15 days per year does not have to report the rental income to the IRS; however, you cannot deduct rental expenses if you don’t report the rental income. Conversely, an investment home can be near the owner’s primary residence. They can even live in one half a duplex and use the other half as an investment property.
5 Things To Consider Before Buying a Second Home
Before buying a second home, you need to consider five things: location, purchasing costs, maintenance costs, mortgage payments, and taxes.
- Location: Will the second home be in a resort, large city or vacation area where activities are abundant and it’s easy to rent when you’re not using it? Or will it be in a rural area where you’ll have more solitude and privacy but perhaps not as easy to rent? To increase the chances of renting it in a country setting, look for a second home on the water or close to a large body of water where renters can swim, water ski, fish or rent a boat.
- Cost to Purchase: Besides the down payment, closing costs and other fees, there will be costs for buying furniture, appliances, and furnishings. Utilities, cable or internet must be turned on and may require deposits. Cleaning, mowing and other maintenance costs must also be factored in. Transportation costs to and from the second home should be considered. Some second homes may have quarterly or annual homeowners association (HOA) dues.
- Monthly Mortgage Payments: Mortgage payments on a second home are usually higher than primary residence rates by 0.5% to 1.0%. In addition, if the down payment is less than 20%, Private Mortgage Insurance (PMI) will likely be added to the mortgage amount, ranging from 0.5% to 1.5%. Therefore, finding a lender with low mortgage rates is essential and one should carefully shop around. An online lender can be just as good as a local one.
If you have bad credit, getting a second home loan will be difficult. Buying a primary residence with bad credit is tough enough, and getting a second home is even more challenging. Fannie Mae requires a minimum credit score of 640 and a 25% down payment for a second home loan. One alternative might be to find a seller who will owner-finance the property. Some lenders specialize in poor credit, but that’s generally on primary residences.
Another possibility is to do a cash-out refinance on your primary home mortgage and use the cash for the second home. If you have enough equity in the home and a large Home Equity Line Of Credit (HELOC), you might also be able to use that to write your own loan. With the HELOC, there are no closing costs and no appraisal fee. The one disadvantage is that the interest rate is variable and could go up in an inflationary era.
- Insurance: Second home insurance will be different from the insurance on your primary residence because you must have ample liability coverage for your guests or renters in addition to the standard dwelling and personal property coverage. Second homes are not typically occupied all the time, so they are at a higher risk for theft and liability. Second home insurance policies are often written on a “named perils” basis, covering only specific events outlined in the policy.
- Property Tax: Property taxes may be tax-deductible but have a $10,000 limit. If you deducted $10,000 or more on your primary residence, the second home property taxes will not be deductible. Mortgage interest may or may not be deductible. You should consult with a Certified Public Accountant (CPA) or visit the IRS website (www.irs.gov) for more information.
Advantages and Disadvantages of Purchasing a Second Home
Advantages:
Ability to defray costs when not staying there:
A major advantage of a second home is that it can be rented to others when not used by the owner. The IRS mandates that for a property to be considered a second home, the owner must use it at least 14 days per year or 10% of the number of days it gets rented, whichever is greater.
Saves money on typical vacation expenses:
For people who like to vacation in the same area every year, having a second home there could save money on hotel rooms and dining out. There is more privacy, and you can remodel the living quarters to suit your taste and lifestyle.
Real estate investment:
Since homes usually appreciate over time, having a second home can provide you with a lucrative and possibly diversified long-term investment for retirement. Many resort and vacation areas in the U.S. have appreciated substantially over the last few decades.
Disadvantages:
Larger down payment requirement:
One disadvantage of purchasing a second home is that you need a 10%-20% down payment, whereas a primary residence can be bought with zero down (VA or USDA loans) or 3.5% (FHA).
Difficulty qualifying for a second home mortgage:
An existing mortgage on a primary residence may increase the difficulty of qualifying for a second home because it raises your debt-to-income ratio. If you qualify, in addition to the larger down payment, you will likely have a higher interest rate on the second home mortgage. Second mortgages also have closing costs that are paid upfront at closing.
You may have to work with a Realtor you don’t know:
If you were buying an investment home near your home, you probably already know two or three good Realtors. However, buying a second home far from your primary residence means working with unknown agents. Perhaps the Realtor who sold you your home can recommend someone in that area. If not, look for a Buyer’s agent with a good reputation in the second home area.
Difficulty in finding tenants and maintenance persons:
Since by definition the second home must be more than 50 miles from your primary residence, you can’t just drop by each time you want to interview a tenant or find a plumber or handyman. You need to rely on quality people from afar and grant them access to the home. One solution is to employ a property manager or use a company such as Airbnb Inc (Nasdaq: ABNB), but you must pay for those services. It may be worth the cost, as they can find qualified tenants and service people quickly and rent your home faster.
When Is The Right Time to Buy a Second Home?
You can buy a second home anytime, but perhaps the right time to buy is when you can easily afford it. If you are struggling to make ends meet and are paying an expensive mortgage on your primary residence, no matter how good a deal you find it’s not the right time to buy a second home. Your second home should be a source of relaxation and pleasure, not an additional financial burden that keeps you awake at night.
At some point in your life, you might decide to move into the second home and sell or rent the primary residence. Speak with a CPA about the tax implications of doing that.
So, it would seem that buying a second home is not as easy as buying your primary residence. Getting a second home loan is trickier, and you are not likely to find a no-credit loan or bad-credit home loan. There are additional costs you may not have considered, and finding reliable service people requires some networking.
On the other hand, the rewards of a second home are many. You may be able to work from your second home, entertain guests or simply relax by the water with a fishing rod in your hands. And when you’re not there, your tenants provide you with the passive income you need to pay the mortgage, utilities and other expenses.