You own your primary residence, but you’re thinking about buying a second home. Congrats! Being in a financial position to make that kind of real estate investment is a major accomplishment, and you should be proud of that.
The first thing you’ll want to do after celebrating your awesomeness is to determine the function of this new home. There are second homes that are exactly that—additional dwellings regularly used by you and your family as a vacation home. And then there are investment properties that are purchased with the explicit intent of renting them out as a source of income.
There are a few key differences between a second home and an investment property. They can impact your interest rate, down payment, ability to qualify, and even taxes. So make sure you’re clear on the goals for your new property from the start. You can also turn to APM or a trusted real estate agent for additional information on these non-primary residences.
Interest Rate Differences
There is a noticeable difference between a mortgage rate on second homes vs. investment properties. Second home loan rates are more like those of primary residences, while an investment property will typically have much higher interest rates. Rates on investment properties are usually 1 to 3 percentage points higher, depending on credit and loan-to-value ratio.
Why is there such a difference between the two types of home? It’s because a rental property is not occupied by the borrower, and most borrowers will be relying on the income that the property generates to fund the home. Those two factors make these loans a much higher risk for mortgage lenders.
Remember that for both second homes and investment homes, your mortgage rate is also influenced by both your credit and your down payment. Of course, the better your credit score and the higher your down payment, the better your rate.
Down Payment Requirements
A typical down payment on a second home is 20%. However, you can find options to put as little as 10% down, depending on your credit rate and other qualifiers. Investments like rental properties, on the other hand, tend to require 20% to 25% down.
A larger down payment can sometimes lower your mortgage rate, regardless of whether you’re thinking about a second home vs. investment property. Keep in mind, too, that items like the interest rate and down payment will impact the size of your monthly mortgage payment.
The Need for Reserves
Reserves are savings balances that will be there after you close on your home purchase. These are seen as emergency funds that assure lenders that you will be able to continue making payments should any unforeseen expenses or income loss come your way.
Some lenders require reserves on second homes, and they almost always require them on a real estate investment like a rental property. These reserve requirements can range from two months to more than six months of your total housing payments. You will want to consider this when determining the amount of your down payment so you don’t completely liquidate your savings.
Debt-to-Income Ratio Calculation
Since this new home will be in addition to your primary residence, you’ll have to include the mortgage on your primary home, plus this new mortgage, into your debt-to-income (DTI) qualifying ratio.
Though you may be able to rent out your second home on a short-term basis, you cannot count that anticipated income in your DTI calculation. If your home is an investment property, however, lenders will generally allow you to count up to 75% of your expected rental income toward your DTI. This can require additional paperwork and even a special appraisal to ensure that your rental figures are comparable to the ones in the rest of the neighborhood.
Proximity to Primary Residence
For your new home to qualify as a second home, lenders will generally require that it be located at least 50 miles from your primary residence. An investment borrower, on the other hand, can live as close or as far from their rental properties as they like.
Regardless of their proximity to their real estate investment, these landlords should have a property manager or property management plan in place to maintain the day-to-day operations and maintenance required for an investment property.
Credit Score Requirements
As you would expect, a high credit score is always favorable for any type of additional home purchase. A borrower buying a second home will typically need a score of at least 640. This can hold true for investment buyers as well, though a score above 680 is preferable.
Tax Benefits and Considerations
Rental income is taxed differently depending on whether you have a second home vs. investment property.
If you own an investment property, the rental income must be declared as part of your taxable income. Those who own a vacation home don’t have to do this as long as their property is rented out for 14 days a year or less.
Investment homeowners do get a few tax benefits, though. They are able to deduct depreciation, in addition to property maintenance, advertising, insurance, and utility expenses. As you might guess, these deductions can go a long way toward offsetting the overall tax impact of the asset’s rental income.
However, if you’re using the property as a second home, you can deduct mortgage interest (up to $750,000 in mortgage debt), property taxes, and mortgage insurance payments.
Discuss Your Real Estate Investment with a Pro
The discussion over whether to purchase a second home vs. an investment property is a personal one. It really boils down to your goals. Are you looking to generate income? Will this be a long-term or short-term rental? When you picture this home, do you see yourself living in it for part of the year, or do you fantasize more about increased cash flow?
There are pros and cons to all types of real estate investments, so establishing what you hope to achieve through this purchase will help determine how you should invest in real estate.
Here’s something else you need to know: You don’t have to make these decisions alone. Reach out to a mortgage adviser at APM—we are here to assist you in this process.
Contact us today to learn more about these two home purchase options and which one may be best for you based on your individual situation.