If you’ve always dreamt of owning a vacation home in the United States or Canada, now is a great time to consider it. With interest rates down and values continually rising, it’s a great way to invest your money and have the luxury of owning a second home.
Check out how to finance a vacation home below and see just how easy it is.
Before buying a vacation home, be sure to also explore our article on How to Buy a Vacation Home: A Practical Guide.
Just like when you bought your primary residence, you can secure a traditional mortgage to buy a vacation home. Most lenders have stricter lending criteria when you buy a home other than a primary residence because the risk of default is higher.
This doesn’t make it impossible to secure vacation home financing, though. Knowing ahead of time the requirements you’re up against will help you ensure you qualify. Here’s what you must know:
- Interest rates can be as much as 0.25% – 0.5% higher than primary residence interest rates. Today’s low interest rate environment, though, makes it a great time to get affordable vacation home financing.
- You’ll likely need a 20% – 30% down payment. To lower the risk of default, lenders require higher down payments. The more money you invest in the home, the less likely you are to default.
- Your maximum debt-to-income ratio should be 43%. This includes the mortgage on your current home, the new mortgage on the vacation home, and any other outstanding debts you carry.
- For borrowers in the United States, the property must typically be at least 50 miles away from your primary residence in order to enjoy the “second home” classification that is coupled with a lower interest rate. For borrowers in Canada, the distance between your primary home and vacation home may similarly be relevant to lenders for the purposes of determining whether you truly intend to use your home for vacation or investment purposes.
- If you rent the property out when you aren’t using it, your bank may classify it as a rental property. Investment properties have tougher restrictions and higher interest rates, so make sure you’re clear on what/how you’ll use the property.
- If you use the property as a rental, you may be able to use up to 75% of the rental income (fair market rent for the area) as income to help you qualify.
Home Equity Line of Credit
If you don’t want a traditional mortgage, you can leverage the equity in your primary residence when deciding how to pay for a vacation home. For this method to work, you must have equity in your home. Most lenders allow you to tap into up to 80% of the home’s value less the amount you owe on your first mortgage (although HELOC loans with federal financial institutions in Canada are limited to 65% of the home’s value). The difference between 80% of your home’s value and your current mortgage balance is the money you can use to buy your vacation home.
HELOC loans have many benefits including:
- Interest-only payments are all that’s required. You only pay interest on the money you withdrew too. For example, if you took out a line worth $150,000, but you only used $100,000, you pay interest on $100,000, not $150,000. After a certain period of time, however (e.g. ten years) you may owe regular principal and interest payments.
- HELOC loans have less strict guidelines than vacation home loans. If you have decent credit and an average debt-to-income ratio, your chances of approval are high.
- HELOC loans have fewer closing costs than a traditional loan because there’s not as much work involved in underwriting and processing the loan since it’s on a property you already own.
Many people use HELOC loans to finance properties that would be difficult to finance through a traditional mortgage. A few key examples include buying land or remote properties that have no comparable sales making lenders wary of lending on them.
A second mortgage is another way to leverage the equity in your primary residence. This is often the best way to use the investment you’ve built in your residence. A second mortgage is a fixed loan, much like your first loan. You pay principal and interest payments on a fixed term, just like your first mortgage.
Most lenders allow you to borrow up to 80% of the home’s value on a second mortgage, just like the first mortgage, if you’re taking the cash out to pay for a vacation property.
The underwriting requirements are a bit tougher than a HELOC because you receive the funds in one lump sum at the closing. You can use the funds for the down payment or to pay for the home ‘in cash’ if you have enough equity.
If you don’t qualify for any of the traditional mortgage options above when deciding how to finance a vacation home, private lenders may be your best option.
Private lenders could be anyone – friends, family, a private investor, or even peer-to-peer lending online. Private lenders set the requirements including the interest rate and term. They’ll assess your qualifications much like a bank would, but based on their own terms, so it’s usually much easier to qualify.
Private lenders usually charge much higher interest rates and/or fees because they’re taking a large risk lending to you. They are investing their capital in you versus investing in the stock market or any other asset. They expect a high return on their investment in exchange for the benefit they’re offering you.
Of course, there’s always the option to pay in cash. If you liquidate assets (sell stocks or another home, for example), you can invest the money in your vacation home. While it may feel like a big leap to spend hundreds of thousands of dollars on a home in cash, it’s an investment.
Since homes appreciate, you’re investing your money, letting it grow, while providing you and your family with the luxury of owning a vacation home to enjoy.
Final Thoughts – How to Finance a Vacation Home
Knowing how to finance a vacation home is one of the most important considerations in the process. Be sure to explore your financing options to determine how to pay for a vacation home and make your family’s dreams come true. Once financing is arranged, you can then proceed with the next steps to buy a vacation home.
If you’re curious as to how much you can afford towards a vacation home, explore our calculators here.