Types of Retirement Plans

Before using retirement funds to buy a second home, you will first need to understand the various types of retirement plans available and the differences between them. Here is a brief overview of the most popular retirement plans in the United States and Canada:

United States

• 401(k): A 401(k) is a retirement plan offered by many companies as a benefit to employees. Generally, an employee can contribute by diverting part of their paycheck into the plan. Many employers will also provide matching contributions as an added bonus. The money in a 401(k) grows tax-free until withdrawn, at which time the account holder will pay income tax on the money taken out.
• Individual Retirement Arrangement or “IRA”. Traditional IRAs are retirement plans that are mostly opened and managed by people themselves. Pretty much anyone with taxable income can contribute to a traditional IRA. For those that don’t have access to an employer’s 401(k), an IRA may be appealing. Tax advantages are similar to a 401(k) where contributions reduce your taxable income and the money grows tax-free until withdrawn. However, there are also important differences between traditional IRAs and 401(k) plans, including the contribution limits.
• Roth IRA. The main difference between a Roth IRA and a traditional IRA is when the tax benefits are realized. With a traditional IRA, your contributions reduce your taxable income but you pay tax when the money is withdrawn. Alternatively, with a Roth IRA taxes are paid on the contributions themselves, but the money can be withdrawn tax-free at retirement. For those individuals that expect to be taxed at a lower rate in retirement, which is the most typical scenario, a Roth IRA may not make the most sense. If the opposite is true, then there may be some benefit to opening a Roth IRA. One of the benefits of a Roth IRA, which is further discussed below, is that early withdrawals are permitted without penalty subject to certain restrictions.

Canada

• Registered Retirement Savings Plan or “RRSP”. An RRSP account permits the account holder to contribute a certain amount of money each year while reducing their taxable income based on their contributions. Once withdrawn, tax is payable thereby permitting you to defer taxes until retirement.
• Tax-free Savings Account or “TFSA”.  Similar to an RRSP, a TFSA is a registered savings account that can hold savings and investments. But unlike an RRSP, contributions don’t reduce your income. Instead, all amounts in a TFSA are based on after-tax dollars and all income earned in the account is tax-free even after it is withdrawn. 

Tax Implications and Other Considerations

The information in this article is provided for information purposes only and does not constitute tax advice. As everyone’s circumstances differ, be sure to speak to a qualified tax advisor.

Now that we have a better understanding of the different types of registered plans, let’s take a closer look at some of the tax implications.

Tax Implications in the US

• 401(k): Generally, if you make any withdrawal prior to the age of 59½, you’ll pay a 10% early withdrawal penalty in addition to income taxes on the amount you withdraw. Withdrawals after the age of 59½, on the other hand, are taxed at your ordinary income tax rate. So age matters. There is an exception, however, where the IRS allows for penalty-free distributions before the age of 59½ in hardship-related circumstances. To qualify, you, your spouse, or a dependent must experience “an immediate and heavy financial need” and the amount you withdraw must be “necessary to satisfy the financial need.” The purchase of a second home would typically not meet this requirement, absent other circumstances. 
• IRA: Similar to a 401(k) plan, any withdrawal prior to the age of 59½ will typically be subject to a 10% early withdrawal penalty in addition to income taxes on the amount withdrawn. And while first-time home buyers are allowed to withdraw up to $10,000 without incurring the 10% penalty, this doesn’t apply to a second home. 
• Roth IRA: With a Roth IRA, you can take out your contributions (as opposed to earnings) at any time without paying taxes and penalties since it’s after-tax money. As soon as you start withdrawing earnings from the account, the amount is typically treated as taxable income. Further, any withdrawal of such earnings prior to the age of 59½ will typically be subject to a 10% early withdrawal penalty. 

In short, unless you’ve reached the age of 59½ and/or you are withdrawing an original contribution amount from a Roth IRA, early withdrawal penalties can be pretty steep.  

Tax Implications in Canada

• RRSP: While the Canadian government does permit first-time homebuyers to withdraw up to $35,000 per year from their RRSP to cover the cost of purchasing a home, the program is not available to purchase a second home. Instead, there are a number of taxes and fees for early withdrawal. In addition to income taxes, you’ll also pay withholding taxes of:
  • 10% on amounts up to $5,000 (5% in Quebec)
  • 20% on amounts over $5,000 up to and including $15,000 (10% in Quebec)
  • 30% on amounts over $15,000 (15% in Quebec)

So if your highest marginal tax rate is 31% and you withdraw over $15,000, more than 60% of that amount will be subject to income and withholding taxes. That’s a steep price to pay. Also, keep in mind that you’ll permanently lose your RRSP contribution room following a withdrawal. 

• TFSA: One of the benefits of a TFSA is that the amounts invested are after-tax dollars. Thus, you’re free to withdraw funds from your TFSA without penalty. Keep in mind, however, that withdrawals will only be added back to your TFSA contribution room at the beginning of the following year. If you over-contribute, you will be subject to a penalty of 1% of the highest excess TFSA amount in the month, for each month that the excess amount stays in your account. 

Other Considerations

Even if you’re comfortable with the penalties, most financial experts will advise that withdrawing funds early from a retirement account is generally a bad idea. Not only will you lose the value of tax-free growth from your retirement account, but it may be difficult to catch up. For instance, let’s assume you withdraw $20,000 from your retirement account to buy a vacation home and plan to repay the entire amount back in seven years. Let’s also assume that, before withdrawing the money, you were earning a reasonable 6.00% annual return. Had you left the money alone, in seven years it would have been worth more than $30,000. Instead, you will now need to come up with an additional $10,000 just to catch back up. Yikes! To make matters worse, you likely only saw a fraction of the original $20,000 after paying all of the early taxes and fees. 

Alternatives to Using Retirement Funds

Before using retirement funds to buy a second home, consider one of these alternatives:

• 401(k) loan: If permitted, a 401(k) loan may be a better alternative if you need money to buy a second home. That’s because the fees associated with a 401(k) loan are lower than a simple 401(k) withdrawal. While qualified 401(k) loans are penalty free, if you leave your current employer the repayment period accelerates to that year’s tax filing date. If your loan is not repaid by then, the remaining balance is treated as taxable income. Also keep in mind that you typically can’t make new contributions while you’re paying back a 401(k) loan. 
• HELOC and other home equity loans: If you have equity built-up in your existing home, then a home equity line of credit or other home equity loan may be the preferred option. In addition to offering flexible financing terms, the cost of borrowing is often lower than a personal loan or other form of unsecured loan.
• Low-down payment mortgage: If you’re struggling to save up for a down payment on a second home and a home equity loan is unavailable, consider whether a low-down payment mortgage is available. In such cases, you may only need 5% to 10% down. Note, however, that most lenders will require 20% or more down on a second home. 
• Government tax credits: While not a complete solution, there are certain government programs that provide access to grants and tax credits. For instance, both the United States and Canada have programs in place where environmentally responsible improvements to your home are made and there are many other programs. 
• Fractional or shared ownership: Buying a fractional or shared interest in a property is a great way to keep costs down. Whether it’s a timeshare in a sunny beach destination or a family cabin shared with relatives, you can greatly reduce your cost of ownership.

Otherwise, don’t rule out the possibility renting instead of owning if the financial strain of ownership is too great.

The post Using Retirement Funds to Buy a Second Home: What You Need to Know appeared first on Vacation Property Online.

As a real estate investor and owner of a vacation home, I explore these questions in greater detail in an effort to help you answer the question: Should I Buy a Vacation Home?  

Why Do You Want to Buy?

Initially, ask yourself why you want to own a vacation home. Have you always dreamed of owning a vacation home to share with friends in family? Or perhaps you’re interested in owning a vacation rental? If, for instance, you’re interested in buying a vacation home primarily for investment purposes, then you will have a much different set of criteria to focus on then say someone looking to buy a family cabin. In short, understanding the motivation behind buying will help better inform your decision so that you can focus on the specific questions to ask.

No matter your motivation, however, here are some things you should consider before buying a vacation home.

Financial Considerations

Can You Afford it?

Determining whether you can afford to buy a vacation home is perhaps the most important consideration. A good rule of thumb is that your total debt to income ratio, inclusive of any debt owed on your primary and secondary residence, shouldn’t exceed 43%. So if your total monthly debts are $2,000/month and your gross monthly income is $7,000, you would have a reasonable debt to income ratio of approximately 28.5% ($2,000 / $7,000). If, on the other hand, your ratio exceeds 43%, then you will either need to reduce your debt or increase your income. Generating rental income from your vacation home while it’s not in use is one such way to increase your income assuming your lender will give you credit. If so, you can expect to receive credit for up to 70% of fair market rents. 

For a better understanding of how much vacation home you can afford, try our Can I Afford a Vacation Home Calculator.

Is It Better to Own or Rent?

Ask yourself how much you plan on using the property and whether you’re okay with taking on the risk and responsibility that comes with ownership. If you plan on using the property for several weeks a year, are comfortable handling most of your own repairs and have the ability to generate revenue from it while it’s not in use, then perhaps buying a vacation property is worth it. From a pure investment perspective, compare different scenarios to see if it’s better to own or rent. If, for instance, real estate is expensive in the area you’re interested in but rent is cheap, then it may be better to rent. The extra money you save could then be invested in something else.

For a useful comparison of owning vs renting a fractional vacation home, explore our article Fractional Vacation Home Ownership: Is it Worth it? In the article you will also find useful inputs such as historical home appreciation assumptions and alternative investment scenarios.

In terms of the responsibilities that come with ownership, keep in mind that owning a vacation home is not truly passive. Even if you pay someone to manage the property or take care of maintenance, you will still need to deal with unexpected issues as they arise and annual obligations related to property taxes, insurance and other matters. If you’re looking for something more hands-off, then perhaps renting is the better option. 

Is It a Good Investment?

Investing in real estate is often seen as a good investment as real estate tends to appreciate over time. You also have the ability to generate rental income and leverage the bank’s money at cheap interest rates. Yet the stock market has historically outperformed the housing market and offers a much more passive investment. Still, there’s no simple answer, especially given the uncertainty as to whether one investment type will outperform another in the future.

If you’re buying on pure speculation that housing prices are going to appreciate significantly then I recommend against doing so unless you have a high risk tolerance. On the other hand, if you can secure a reasonable interest rate on a mortgage and have the ability to generate rental income, it may just be a good investment over the long term.

Be sure to check out our investment property calculator, which provides a comparison of the expected return on investment from a vacation home vs the stock market.

Weighing the Pros and Cons

Any response to the question should I buy a vacation home will need to take into account the pros and cons of owning a vacation home. Here are a few that come to mind:

Pros

• Pride of ownership.
• Spend quality time with friends and family.
• Real estate is a fairly secure investment without the same volatility as other asset classes. 
• Borrowing is affordable, even if interest rates are typically higher for second homes.
• Ability to generate short term rental income.

Cons

• Additional carrying costs could put a strain on finances and/or delay retirement.
• From an investment perspective, the stock market may in fact be more attractive over the long term.
• Ownership is not passive. 
• In my experience, you may not use the property as much as you would like.

For a more complete overview of the pros and cons of owning a vacation home, explore our article here on everything you need to know before buying a second home.

What It’s Like to Own a Vacation Home

Having owned a vacation property for several years now, I can attest to the fact that, in many respects, the joy that vacation home ownership brings is truly priceless. Sure you can likely rent a comparable property but there’s something special about owning your own property. And while studies have shown that experiences bring more happiness than possessions, you get the best of both worlds with a vacation home. After all, you can take pride in ownership all the while enjoying the experiences with friends and family along the way.

Yet, I also need to deal with certain realities, including the following:

• Unexpected issues such as water/fire damage or theft do arise from time to time
• As I rent out my property while it’s not in use, I need to report my income to the appropriate tax authority
• For peace of mind, and in order to comply with the terms of my insurance which require my property to be vacant for no more than 30 consecutive days, I had to hire a property manager to check-in on the place from time to time.
• My annual maintenance costs total approximately $7,000, which is equivalent to approximately 1.0% of my home’s value. This is on the low end of the general rule of thumb that you can expect to spend 1 to 4 percent of your home’s value every year for maintenance. As such, I expect this amount to increase over time. 
• With my second child on the way, we’re at risk of outgrowing the property

While these items are specific to my personal circumstances, the point is that it’s a big commitment owning a vacation home. Still, I have never regretted buying my  property.

Should I Buy a Vacation Home? Final Thoughts

Before buying a vacation home, take the appropriate time to better understand the implications of doing so. Do your research, talk to your financial adviser and discuss other people’s experiences as vacation home owners. Importantly, get to know the area you’re interested in and rent before you buy to ensure it’s an area you can see yourself spending a significant amount of time. 

The truth is, the only person that can answer the question “should I buy a vacation home” is you. Good luck!

Be sure to also explore my guide on how to buy a vacation home.

The post Should I Buy a Vacation Home? Suitability, Finances and More appeared first on Vacation Property Online.

Fortunately, this doesn’t mean you’re out of luck. There are still many ways to obtain vacation home financing today.

Different Types of Vacation Home Loans

Despite the unique current state of the market, you have options when securing vacation home loans that might include a second mortgage or HELOC. Here are the most common options.

Second Mortgage

If you own a property now and have enough equity in it, you might be able to borrow against it to buy a second home. A second mortgage usually has slightly higher interest rates because the loan is in second lien position which means a higher rate of default. Second mortgage loans have fixed interest rates and you receive the funds in one lump sum.

Cash-Out Refinance

Another way to tap into your primary home’s equity is with a cash-out refinance. If you have a high interest rate on your first mortgage right now, you might even save money with a cash-out refinance by lowering your loan’s interest rate.

A cash-out refinance allows you to tap into up to 80% of your home’s equity. First, the funds pay off your existing mortgage. Any difference in funds between the loan amount and your loan payoff are yours to use for your vacation home.

HELOC

A home equity line of credit or HELOC is a form of a second mortgage on your primary residence. You borrow a line of credit, much like a credit card, and use the funds as you need. You only owe interest on the amount you withdraw. In the US, this typically goes on for 10 years. After such time, the loan goes into repayment where you owe both principal and interest. In Canada, most HELOCs have an indefinite term where you can either make interest-only payments or also repay the principal.

If your HELOC has a variable rate of interest, make sure you can afford the ‘worst case scenario.’ 

Traditional Mortgage

When considering vacation home loans, you could choose a traditional mortgage for a second home. Just keep in mind, the interest rate on second home loans are typically 0.5% – 0.75% higher than rates on a primary residence.

Different Sources of Vacation Home Loans

Since vacation home financing can be harder to get, there are different sources of loans you can tap into to get the most affordable loan on the best terms.

• Banks – Your local bank can be a great resource if you have great credit and a good relationship there. The process can take longer at banks, though, so keep that in mind.
• Credit unions – If you belong to (or can belong to) a credit union, check out their rates on vacation home loans. They often offer competitive rates and terms.
• Mortgage lenders – Mortgage lenders only offer mortgage loans which differs from the full suite of products and services that banks offer. For this reason, the process usually goes faster and they usually have more options, which is good if you have less than perfect credit.
• Private lenders – If the above sources don’t work out, private lenders usually offer options for people with unique financing circumstances.

How to Qualify

Qualifying for vacation home financing will vary based on the source you use. For example, a mortgage lender often has the most options and can work with many credit types and situations. A private lender usually assumes more risk too, which gives you another option if you have less than perfect credit, but it comes at a price such as higher rates and less attractive terms.

On average, you’ll need the following to qualify:

• At least a 640-credit score
• A 20% down payment
• A debt-to-income ratio that doesn’t exceed 43%
• 2 years of stable and consistent employment and income
• Cash reserves (liquid assets)
• No recent bankruptcies or foreclosures

How Much Can You Afford?

Try the calculator below to determine how much vacation home you can afford.

How to Secure a Vacation Home Loan and/or Increase Borrowing Capacity

Securing vacation home financing is a bit more difficult than primary residence financing, but here are some ways to increase your chances of approval:

• Improve your credit score

The higher your credit score is the more likely you are to get approved. Not only will you get approved, but you’ll get better rates and terms which can increase your borrowing capacity. Take care of late payments, pay down credit cards, and don’t open any new credit leading up to your mortgage application.

• Pay down your credit card debt

Keep your debt-to-income ratio as low as possible by paying down any consumer debt, especially credit cards. This leaves more room for a vacation home loan payment in your DTI.

• Put down a large down payment

Second homes usually require a much higher down payment than primary residences. You’ll need at least 20% down, but if you can afford a higher down payment, you’ll increase your chances of approval and your borrowing power. 

• Stabilize your income and employment

Lenders look for stable employment and increasing income over the last couple of years. Show employment stability (you don’t change jobs often) and that your income remains steady or increases regularly).

• Shop around

Get pre-approved at several lenders (including different types) to see what options you have. For example, if a credit union gives you a lower rate, you might have more borrowing power compared to going with a mortgage lender that’s charging higher rates.

Final Thoughts

Vacation home loans might be a little harder to come by today, but there are still many options. The key is to improve your credit score and lower your debt-to-income ratio to show you are a good risk. The more money you have to put down on the home too increases your chances of approval because it lowers the bank’s risk and increases your ‘skin in the game’.

The post Vacation Home Loans: Everything You Need to Know About Your Financing Alternatives appeared first on Vacation Property Online.

But before buying a vacation property that will be your primary residence, there are several things you should consider first. With this in mind, here’s what you should know.

What to Consider Before Buying a Vacation Property That Will Be Your Primary Residence

Before you buy a second home that will be your primary residence, take the time to consider the following:

Current Needs vs. Future Needs

Consider whether the home will meet your current and future needs. How do you initially plan to use the vacation property? If you will be using it as a vacation rental property, then it will have a different set of considerations from, say, a weekend home. Do you subsequently plan to retire in the home? If so, perhaps a three story property on acreage is not the best choice, even if it would serve as a great family retreat in the meantime. Don’t fall into the trap of focusing on things as they exist today. Instead, consider how the home will meet your needs over the near term as well as the next 10-20 years.

Even if the home doesn’t meet your current or future needs, do you have the ability to renovate it? Since you won’t be living in the home right away, it may be the perfect time for renovations. This could also be a great way to save money by buying a “fixer upper”. And, since 100% of any gain realized upon the sale of a “second home” is taxable in both the US and Canada (more on that later), it may be advantageous from a tax perspective to complete expensive renovations while it is still your second home in order to increase your adjusted cost basis. By increasing your cost basis, it will help reduce any gain realized on a sale and thus your corresponding tax obligation.

Your Circumstances May Change

No matter how much planning you do, your needs and/or circumstances may change. Perhaps your kids live at home longer than expected while they attend university. Or perhaps the opposite is true and your kids move further away to attend university or pursue career opportunities. In the former case, the transition to your second home may be put on hold and in the latter case you may decide that you don’t want to move into your second home altogether. Take the time to ensure you have an exit strategy or a back-up plan in order to deal with a change in circumstances.

Finances

Before buying a vacation property, crunch the numbers to ensure you can afford it. Speak with your financial advisor to determine the suitability of buying a vacation property. As general guidelines, you should expect to come up with at least 20% of the purchase price as a down payment and have a debt-to-income ratio of no more than 43%. Be sure to explore our article on How Much Second Home Can I Afford for more detailed information on affordability criteria.

Assuming you need financing, do you qualify for a second home mortgage? Second home mortgages are harder to qualify for than primary residence mortgages. If you don’t qualify, do you have equity in your primary residence you can cash-out and use to buy the home? Here are a couple of ways to finance a second home using the equity from your primary residence:

• HELOC – A home equity line of credit gives you access to up to 80% of your home’s value minus any outstanding mortgage balances. You can draw from your credit line at any time, and only owe interest on the money withdrawn.
• Second mortgage – You can also take out a second mortgage on your existing home, otherwise known as a home equity mortgage. This loan has a fixed interest rate, and you receive the funds all at once. You’ll then owe principal and interest on the borrowed amount.

Tax Planning

Before making such a significant purchase, speak with a qualified tax professional. After all, decisions you make now may have implications on your tax obligations in the future. While we go into a bit more detail on some of these tax consequences later on, be sure to obtain tax advice both before moving forward with the initial purchase and before converting it into a primary residence.

What to Consider Before Converting a Vacation Property to a Primary Residence

If you already own a vacation property, you should consider the consequences of converting a second home to a primary residence, including:

Mortgage Terms

If you took out a mortgage to buy a vacation property, you may be eligible to refinance it at a lower rate once you live in it full-time. Primary residences have better terms because you’re more likely to pay the mortgage on time and not risk losing your home. You can expect interest rates to be as much as 0.25% – 0.5% higher for second homes. As such, speak with your lender and be sure to take advantage of lower rates for primary residences (if not at the time you convert your second home to a primary residence then when your mortgage is up for renewal).

Don’t forget to consider the mortgage terms of your first mortgage as well. If you’ll be selling your primary residence, ensure the mortgage on that property doesn’t have a prepayment penalty or that you can port it to your second home.

Look at the big picture and determine how you can structure your home financing so that it costs you the least amount of money.

Home Insurance

When you switch your vacation property to a primary residence, you may also save money on home insurance. Just like a mortgage lender thinks a second home is riskier, so does your insurance company.

When you convert your vacation property to a primary residence, your insurance costs will decrease. Talk to your insurance agent about the differences so you know what to expect.

Tax Consequences

Whether you’re in the United States or Canada, there are tax consequences when converting a “second home” to a primary residence. Here’s a summary of things to consider.

Note that tax rules are complex and everyone’s circumstances are different. Accordingly, you should consult a qualified tax adviser in connection with your own tax planning.

United States

• You may get a capital gains exception on the money earned on the sale of your primary residence. The amount you can exempt depends on if you are single ($250,000) or married filing jointly ($500,000).
• If you sell your second home, any capital gains will be taxed as long-term capital gains if you have it for at least one year. The tax rates are 15% or 20% depending on your taxable income. This gives you a “way out” if you decide to sell your second home before moving in full time, albeit with a tax hit on any capital gains.
• When converting your second home to a primary residence, you can get the capital gains exclusion as long as you live in the home as your primary residence for at least two of the last five years. The capital gains exclusion is on a prorated basis, however, depending on how much of the time you owned the second home as a vacation home or other “non-qualifying use”. For example, if you have been living in it full-time for two years after using it for five years as a vacation home, your prorated exclusion limit will equal 2/7 (i.e. 2 years of full-time use over a 7 year period) of the gains. So instead of taking advantage of the full $250,000 exemption, it would be reduced to $71,430 (2/7 x $250,000) to reflect the period during which the property was used as a primary residence.

Canada

• When you sell your second home in Canada, all gains are subject to taxation. This isn’t the case for your primary residence, however. Those capital gains are tax-free.
• If you sell a second home for more than you bought it for, half of the capital gains are included in your taxable income.
• When you convert a second home to a primary residence, the CRA treats it as if you sold the home. This is called a “change in use“.
• If you convert a primary home to a second home, you don’t have to pay capital gains tax up to the point of conversion.
• If you convert a second home to a primary residence, you’ll pay capital gains tax on any gain up to the point you converted it. So if your second home has appreciated $50,000 by the time you move in, half that amount, or $25,000, will be subject to taxation.

Final Thoughts

Before buying a vacation property or “second home” that will be your primary residence, consider the transition carefully. Think of not only how well the home will suit you and your family, but also the financial consequences of the change. In many cases, it can be a strong move financially, but understanding how it works, what it will cost you, and how it will affect your taxes is important before deciding to convert your vacation property to a primary residence.

The post Buying a Vacation Property or “Second Home” That Will Be Your Primary Residence: Important Considerations appeared first on Vacation Property Online.

While there are different meanings of the term “fractional vacation home ownership”, in simple terms such ownership involves several buyers each holding an equal part of title to the vacation property. Fractional vacation home ownership differs from a timeshare in that with fractional ownership you own real estate whereas with a timeshare you have a right to use a property.

There are certainly drawbacks with owning a property with other people because there’s more than one opinion or voice in any decisions pertaining to the property. Yet for many people, the benefits outweigh the drawbacks. With this in mind, let’s take a closer look at whether it’s worth it to buy a fractional vacation home. 

What you Should Know Before Considering Fractional Vacation Home Ownership

Owning a fractional vacation property comes with some unique considerations. Knowing what you should consider before you jump in headfirst into a shared vacation home is important. Here are some things you should think about.

Understand What you Own

Before you buy into fractional homeownership, consider what you own. Is it a traditional ski resort model where you buy a quarter interest and get a quarter use of the property? In this case, you own part of the property, giving you ownership rights, like you would have if you owned a home.

Other ownership models like those of certain private residence clubs give you rights to the club amenities and services, but you don’t have any ownership rights to the property itself.

Rights and Liabilities

Before you buy a shared vacation home, understand the rights and liabilities you’ll have or incur. Do you have pre-determined usage rights where you get to use the property for a portion of the year or is it a pay-for-use situation where you pay for the time you use the property, as do your co-owners?

As far as liabilities or responsibilities, consider:

• Who manages the property?
• Who makes decisions on how the property is handled, renovated, etc.?
• Who pays the expenses? How are they divided?

To get a more detailed understanding of what a property allows/requires, read the organizational documents, including any co-ownership agreements.

Annual Costs

In shared ownership arrangements you pay the proportion of the ownership. For example, if you have 25% ownership, you pay 25% of the expenses. In a pay-for-use approach, you are responsible for usage fees, which come out of your rental income. If your usage fees exceed your portion of the rental income, you’d owe the difference. 

Annual fees typically cover all maintenance costs and reserve requirements to cover the cost of any future updates or renovations.

Financing

It’s often much harder to get financing for fractional vacation ownership. If you can find a lender, you’ll likely have to meet strict requirements and have a large down payment. For this reason, it’s often best to invest in fractional homeownership when you can pay for your portion in cash.

Selling the Property

Owning a property with others means you often can’t decide to sell the property without their consent. In most cases, all parties must be on board. Your organizational documents may prohibit the sale of one partner’s ownership without the consent of every owner. In such circumstances, the only way you may get out of it is by selling to another co-owner.

Is Fractional Vacation Home Ownership Worth it? 

In order to answer this question, let’s take a closer look at renting vs owning a fractional vacation home and whether owning one is a good investment.

Renting vs Owning

When you own a fractional vacation home, you only have rights to it for a part of the year. For this reason, you may be asking yourself whether it would be better to rent a vacation home instead of own a fraction of a vacation home? So let’s consider an example. Let’s say a ski chalet in your favorite winter destination has recently come on the market for $40,000. For the purchase price, you will receive a ¼ interest and four weeks of personal use per year. Annual fees are $1,000 per year, increasing with inflation at approximately 3.0% annually. Let’s also assume that the value of the property appreciates in line with historical norms at 4.0% annually. Instead of buying a fractional interest, you could rent a comparable unit for $200 per night. Under the rental scenario, let’s also assume that rental rates increase with inflation at 3.0% annually and instead of investing $40,000 in real estate you invest in the stock market, realizing an annual return of 8.0% per year (slightly below historical norms). Here’s what these scenarios look like after 10, 20 and 30 years:

Ownership Scenario

Rental Scenario

Using the above scenarios, there doesn’t appear to be a clear winner. In the ownership scenario, you would be further ahead in years 10 and 20 but that changes in year 30 where renting appears to make more sense. Of course, the above scenarios are an oversimplification of the actual calculations and there are various assumptions that could prove to be incorrect. By going through this exercise, however, the answer may be clearer depending upon your circumstances. 

Do Fractional Vacation Homes Make Good Investments

You have many options to invest your money, so is a shared vacation home a good way to use your money? Like any savvy investor, a diversified portfolio is a good idea – it prevents a significant loss should one asset decline in value. But does it make sense to add fractional vacation home ownership to your investment portfolio? Here are some things to keep in mind:

• You only own a fractional interest in real estate, so you will feel less of an impact with the ups and downs of the market. Historically, though, the stock market outperforms real estate. Real estate only slightly beats inflation, whereas stocks have an average annual return of 9% – 10%. But comparing real estate to stocks is in many ways an apples to oranges comparison. Therefore the best situation is to invest in both – diversifying your portfolio.
• If your property is a part of a rental pool, focus on the net proceeds. How much will you walk away with after annual maintenance costs and other required fees? While the rent you bring in may look attractive, the annual carrying costs can pile up quickly. 
• Fractional interests are hard to liquidate. When you invest in stocks or bonds, you can sell them on the open market. When you want to liquidate a real estate investment that you own with others, you often must get their approval. For this reason, there are typically less interested buyers. Given shifting consumer preferences towards fractional ownership, however, that may be changing.

To determine what your rate of return might be based on various input scenarios, try our Real Estate ROI Calculator. 

Final Thoughts

If you are clear on the ownership rights and limitations, owning a shared vacation home can be well worth it. The pride of ownership and enjoyment of the property may outweigh the drawbacks, including the lack of control over decision making and the difficulty in reselling your fractional interest.

If you’re buying the property for investment purposes, you may have other (better) options including renting a comparable property versus owning it. The annual costs, for instance, can be quite high. Yet, investing in real estate is often a wise decision and there are benefits to buying a fractional interest, including being less exposed to market price fluctuations.

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The Difference Between a Second Home and an Investment Property

Lenders must know what you’re doing with a second home since it can have many roles in your life. Any property that isn’t your primary residence could be a vacation home, part-time residence, or an investment property.

A “second home” is a property you use for your personal use. You may use it as a vacation home, visiting only a couple of times a year or as a part-time residence if you live in multiple areas, such as spending the winters in Florida and the summers in Chicago. You might even buy a second home that will eventually become your primary residence.

An “investment property” is a property you rent out to others. Lenders take a vested interest in this because investment properties have a much higher risk. You are more likely to default on the loan if your renter defaults and abandon the property than you would a property you use yourself.

So, while the guidelines in this article generally apply to second homes, lenders may have heightened down payment requirements for investment properties. Keep in mind, if you buy a “second home” in the United States, it must be at least 50 miles away from your primary residence for you to take advantage of the more lenient guidelines for second homes versus investment homes. 

Minimum Down Payment for Second Home

Any time you’re buying something other than a primary residence, you’ll need a larger down payment. Lenders require more “skin in the game” to offset the risk of default that second homes and investment properties have.

Since FHA loans aren’t an option for anything except primary residences in the United States, you’ll need conventional financing or a portfolio loan from a private lender. Either way, lenders typically require between 20% – 25% down on a second home to make it less risky for them. If you use the property as an investment property, they may require an even higher down payment.

In Canada, you may still get away with a down payment lower than 20%, but you’ll pay mortgage insurance on the loan until you owe less than 80% of the home’s value to make up for the risk. If you have a 20% down payment, you’ll increase your chances of securing conventional financing and you’ll avoid mortgage insurance. 

How Does a Higher Down Payment Impact Your Mortgage?

With a higher down payment, this lowers the risk profile from a lender’s perspective since you have more to lose should you default on your mortgage. As a result, you will likely have a larger pool of lenders willing to loan you the money at more competitive rates. This also means that you will need to borrow less money, resulting in lower interest payments over the life of the mortgage and lower monthly payments. Alternatively, you could stick with the same monthly payments that you would otherwise be making with a lower down payment and pay-off your mortgage quicker.

For the purposes of illustration, let’s look at some examples using the mortgage calculator below. Let’s assume you’re interested in buying a condo on the beach for $300,000. A bank is willing to provide you with a 30 year mortgage at an interest rate of 3.0% annually.

Note: for more detailed calculations, including a complete amortization schedule, try our Vacation Home Mortgage Calculator.

Scenario 1: Lower Monthly Payments

Using down payment scenarios of 10%, 20% and 30%, the table below shows the impact on your monthly payment and total interest.

So if you want to save over $250 a month in mortgage payments and more than $30,000 in interest, putting down 30% vs 10% will be the best option.

Scenario 2: Shortened Mortgage Period

If you’re hoping to pay off your mortgage as quickly as possible, then a higher down payment and shorter mortgage period may be a better option. Using the above scenario, let’s say you’re deciding whether to put 20% or 30% down. As illustrated in the above table, your monthly mortgage payment with 20% down equals $1,011.85. If instead you decide to put 30% down, then by making roughly the same monthly payments (~$995.84) you would be done paying your mortgage in 25 years. You’ve now shaved off five years of your mortgage and saved more than $35,500 ($124,265.89-$88,753.13) in aggregate interest payments.

As you can see, under either scenario you end up paying less interest because you’re borrowing less money.

Three Ways to Use Equity from Primary Residence to Come Up with Down Payment

In the US, you can typically borrow up to 80% of the home’s value, but this includes the amount of your first mortgage too. You can usually take out the difference and use it to meet the minimum down payment for a second home.

In Canada, you can borrow up to 65% of the home’s value, using the difference between the loan amount and your first mortgage as your down payment.

So how do you tap into your home’s equity to buy a second home? Here are three simple ways:

Home Equity Line of Credit

A home equity line of credit is a second mortgage on your property with a variable interest rate. It works like a credit card, where you can draw funds, using them how you need and make interest payments only on the amount you withdrew. 

Your interest rate may change monthly and you must make principal and interest payments to repay the amount you borrowed. In the US, repayment of the principal begins after ten years whereas most HELOCs in Canada have an indefinite period.

Home Equity Loan (Second Mortgage)

A home equity loan is a second mortgage with a fixed interest rate. You make principal and interest payments right away and receive the full amount up front. At closing, the lender takes second position on your existing mortgage. You can’t withdraw funds repeatedly like you can with a HELOC, but you have the reassurance of a fixed rate mortgage.

Cash-Out Refinance

A cash-out refinance is a refinance of your first mortgage. You pay off your first mortgage and receive the difference between the new loan amount and the payoff in cash to use as your down payment. Since it’s a first mortgage, it’s less risky for lenders and you may secure a lower interest rate.

Other Qualifying Criteria to Buy a Second Home

To qualify for a loan for a second home, you must generally meet the following requirements:

• Minimum 640 credit score, but a credit score over 700 increases your chances of approval and lowers your interest rate
• Maximum debt-to-income ratio of 43%, which includes the new mortgage and any existing debts
• Strong history of stable income and employment for at least the last two years
• No recent public records, such as a foreclosure or bankruptcy
• Proof you can balance both mortgages without relying on uncertain sources of outside income

Final Thoughts

The minimum down payment for a second home and other requirements are stricter than when you bought your primary residence. This is due to the increased risk profile of a second home. Before securing financing, you’ll need to differentiate between how you’ll use the home. Will it be a second home, or will you rent it out? There’s a big difference to lenders.

You must also ensure you qualify for the loan. Because you won’t live in the property full-time, lenders take a much higher risk lending you money. They’ll do their due diligence, ensuring you are a good risk and can afford the payments in addition to your current mortgage, if your primary residence still has a mortgage.

If you meet the relevant qualifying criteria, you can expect that most lenders will require a minimum down payment for a second home of 20% or more. 

The post What is the Minimum Down Payment for a Second Home? Guidelines, Mortgage Criteria and More appeared first on Vacation Property Online.

How to Buy a Vacation Home: Introduction

As I reflect on the topic of how to buy a vacation home, I am naturally drawn back to when I bought my first vacation home. In particular, I remember how much information was thrown at me. From understanding how much I could afford to weighing the pros and cons of a vacation condo vs a vacation home, there is a lot to take in. Somehow, an experience that’s supposed to be exciting and filled with joy can quickly turn into a stressful one.

With this in mind, in this article I provide a practical guide on how to buy a vacation home. By following these steps, you will be in a better position to ensure a smooth buying experience. So let’s get started. 

For a more complete guide on everything you need to know before buying a second home, explore my article on Buying a Second Home: Everything You Need to Know Beforehand.

Determining Whether Buying a Vacation Home is Right for You

Like any big purchasing decision, you should first determine whether buying a vacation home is right for you. First, you should reflect on why you would like to own a vacation home. For instance, buying a vacation home for family use will have different considerations than buying a vacation rental property. In my case, I purchased my vacation property for both personal use and as a vacation rental. As such, I had to consider it from multiple perspectives. In particular, here are some common reasons to buy a vacation home and relevant considerations for each:

• Personal/Family use. For vacation homes that are primarily bought for personal or family use, it’s important to set reasonable expectations in terms of how much you will actually use the property. In my case, I find I use my property less often than originally expected because life gets busy. When I’m not using it, however, I’m able to rent it out. The last thing you want to do is make a significant investment in something that you won’t get your money’s worth out of. If you’re buying a vacation home with other family members, be sure you have a plan in place to deal with an eventual sale of the property. 
• Vacation rental. When buying a vacation rental, you’ll need to take into account such things as the local short-term rental regulations, the revenue potential of the property, property management, tax implications and other similar considerations. Even if short-term rentals are permitted in the area, if the property is subject to a home owners association or strata counsel, there may be further restrictions in the governing documents. 
• Retirement. Planning for retirement has its own unique set of considerations, especially from a financial planning perspective. Will buying a retirement home early set your retirement back a few years? If so, it might not be worth it. One of the obvious benefits of owning a vacation home in the interim is that you can get comfortable with your new home over time before you move into it full-time.
• Investment. Investing in real estate is often seen as a wise decision over the long term. Yet, historical returns show that real estate has been outperformed by the stock market. Still, there are other benefits to investing in real estate such as generating rental income and leveraging the bank’s money. Try our Real Estate ROI Calculator here to help you determine whether investing in a vacation home is right for you. 

Once you’ve determined that buying a vacation home is right for you, next you will need to arrange financing. 

Arranging Financing

Before arranging financing, you will need to determine how much vacation home you can afford.

How much can you afford

Here are some general affordability guidelines to follow:

• Down payment. Be prepared to come up with at least 20% or more of the purchase price as a down payment as opposed to 5-10% on a primary residence. Second home lenders will typically require larger down payments given the heightened risk of default on vacation properties. 
• Debt-to-income ratio. Your debt-to-income ratio is a measure of your gross monthly income that goes to paying your monthly debt (total monthly debt payments divided by gross monthly income). Second home lenders use this ratio to determine your ability to service another mortgage. A good rule of thumb is to ensure a debt-to-income ratio of no more than 43% overall. 
• Rental income. If you plan on renting out your vacation home while it’s not in use, you may be able to get credit for up to 70-75% of the fair market rents. By doing so, you can reduce your debt-to-income ratio to a more manageable level. Not all lenders, however, will take rental income into account. 

Be sure to also try our Can I Afford a Vacation Home Calculator to better understand how much you can afford.

Explore your financing options

Once you understand your budget, you will need to explore your financing options, which may include: 

• Second home mortgage. When I purchased my vacation home, I took out a second home mortgage. In my case, I put 20% down and my interest rate was slightly higher than an interest rate for a primary residences. In fact, you can expect to pay rates that are 0.25% to 0.5% higher than you would for a primary residence.
• HELOC. If you have equity in your home, you may be able to borrow against it at a reasonable rate by opening a home equity line of credit. A HELOC acts like a credit card where you draw down on it and only pay interest on the amount borrowed. 
• Second mortgage. This is another way to leverage the equity in your primary residence. A second mortgage is a fixed loan on your existing home, much like your first mortgage but in second position, where you pay principal and interest payments on a fixed term.
• Private lender. Where traditional bank financing is not available, private lenders may be an option but be prepared to pay higher interest rates and other fees.

Settling on a Vacation Property Type and Location

Now that you’ve arranged financing, you’re almost ready to search for your vacation home. Before doing so, however, you will need to settle on the property type and location. After all, budgetary constraints could place limitations on where and what you buy.

In my case, I opted to buy a condo given that it represented an affordable alternative to a house and offered convenience and reduced maintenance obligations. Yet others may prefer the space and privacy of a house or cabin in the woods. There’s no right or wrong answer here so you’ll need to decide what’s right for you. 

The area you purchase is also an important determination. In my case, it was important for me to be within a two hour drive of my home given that I wanted to use my vacation home on weekends. For that reason, there were only a handful of locations for me to consider. If you’re still mulling over certain locations, I recommend staying in a vacation rental in the areas you’re interested in so that you can get a better feel for each location.

For a list of some of the best places to buy a vacation property in the United States, explore our articles on the best places to buy a vacation property in California, Michigan and Pennsylvania. For a list of the best places to buy a vacation property in Canada, click here. 

Once you’ve settled on a property type and location, you can then begin searching for a property. 

Searching for a Vacation Home

With the help of a realtor, search MLS listings in the area within your price range. Attend open houses to get a better feel for what is being offered at different price points. Your realtor will also have access to recent sales history so that you know how much properties are actually selling for in your area. In hot real estate markets, you will be expected to have your financing pre-approved and you may have limited ability to include “subject clauses” in your offer. In order to conduct a property inspection, you may want to have a company lined up to do the inspection on short notice, including any relevant experts such as asbestos detection, well testing, elevation certificates for waterfront properties etc.

Submitting One or More Offers and Closing

After finding the perfect property, you will need to submit an offer and, once accepted, close the transaction. Depending upon market conditions, you may also need to submit multiple offers before one is accepted so you may need to be patient. Following acceptance, you will need to sign a bunch of documentation to finalize the mortgage and transfer title to the property. From there, you get the keys and gain possession of the property. 

And that’s how to buy a vacation home. You now have the keys to your very own vacation home!

How to Buy a Vacation Home: Other Tips

• Be sure to work with a qualified tax professional to better understand the tax implications of owning a vacation home
• If you’re buying in a foreign jurisdiction, take the appropriate time to complete necessary due diligence on the area and arrange financing (if available).
• Owning a vacation home isn’t passive and therefore be prepared to deal with annual maintenance obligations and unexpected repairs.

The post How to Buy a Vacation Home: a Practical Guide appeared first on Vacation Property Online.

If you’re thinking about taking out a mortgage for an additional property, whether through a HELOC, second mortgage or other second home financing, lenders in the United States and Canada will look closely at your debt-to-income ratio for a second home. 

In this guide, we’ll look closer at debt-to-income (DTI) ratios and lender requirements in the context of buying a second home. 

What is a Debt-to-Income Ratio and Why is it Important?

Your debt-to-income ratio is a measure of your gross monthly income that goes to paying your monthly debt (total monthly debt payments divided by gross monthly income).

The higher your DTI ratio is, the more income you have committed to your monthly debts. A high DTI ratio means you’re a higher risk of default and may not be able to take on another loan. A low DTI ratio means you may be able to take on more debt and pay everything on time.

When you’re shopping around for the right lender to buy a second home, remember this – major banks typically required lower debt-to-income ratios. They have strict guidelines because they have only a few programs to fit borrowers into and they don’t have much leeway. On the other end of the spectrum, private lenders, take larger risks and allow higher DTI ratios in exchange for higher interest rates and fees. 

What is the Maximum Debt-to-Income Ratio for a Second Home?

On the low end, lenders prefer a maximum 36% debt-to-income ratio, but some lenders will go as high as 43%. These are just guidelines set by the government agencies investing or backing the loans. Each lender can make its own decision on a case-by-case basis, allowing them to accept higher DTI ratios if borrowers have compensating factors, such as a high credit score or a large amount of savings (reserves) on hand.

In the United States, many lenders mandate a maximum 43% debt ratio because that’s the highest ratio allowed for a loan to be considered a Qualified Mortgage (QM). A QM is a loan the lender did its due diligence on to ensure you could easily afford it and won’t be subject to financial distress. 

In Canada, some lenders can accept DTI ratios up to 44%, which is the highest debt ratio allowed for CMHC’s Homeowner Mortgage Loan Insurance. This insurance is what allows borrowers to secure financing with less than a 20% down payment.

Whether you’re in the US or Canada, the debt-to-income ratio requirements will vary based on your other qualifying factors including the amount of money you put down on the home and your credit score. For example, Fannie Mae allows a DTI ratio up to 45% if you have at least a 660 credit score and 25% or higher for a down payment. In short, the better your other factors are, the higher the DTI ratio a lender can accept.

How to Calculate Debt-to-Income Ratio For a Second home

To calculate your DTI ratio, use the following formula: total monthly debt payments / gross monthly income = DTI ratio.

Now let’s look at a hypothetical example. Susan is interested in buying a beach house in Palm Beach, Florida but would like to better understand what she can afford. Here is a snapshot of her finances:

• Monthly employment income (before taxes): $8,000
• Monthly mortgage payment on primary residence: $1,300
• Other monthly housing expenses on primary residence (property taxes/insurance): $200
• Monthly car loan payment: $250
• Savings for down payment: $105,000

Using the above figures, Susan currently has a debt to income ratio of 21.875% ($1,300 + $200 + $250 / $8,000). Now let’s see what she can afford using the debt-to-income ratio calculator below.

Be sure to explore the debt-to-income ratio calculator yourself to understand what you can afford in a second home. Simply input the relevant amounts to determine the maximum amount you can afford based on your debt to income ratio.

Assuming an interest rate of 3.0% on a 30 year mortgage, Susan can afford a further monthly mortgage payment of up to $1,690, which means she can afford a second home mortgage in the amount of $400,850.  With a down payment of $105,000, she can afford a vacation home worth approximately $505,000. But now let’s assume that another home has recently come on the market for $575,000, which is in excess of her limit. Yet, by factoring in her anticipated rental income, she can afford it. Here’s how. Let’s assume that she can rent out her vacation home part time through Airbnb while it’s not in use for $1,000/month and that her bank is willing to give her credit for up to 70% of the fair market rents. Using the calculator, she can now afford a second home mortgage of up to $472,244 and a vacation home with a purchase price of approximately $577,000 (after factoring in the down payment). 

Note that mortgages for second homes will typically be associated with stricter lending criteria and higher interest rates than primary residences. For an investment property, such as a vacation rental, you can expect interest rates to be even higher and even higher down payment requirements.

5 Ways to Improve Your Debt-to-Income Ratio

Fortunately, your debt-to-income ratio can change. You are in control of it and can help your DTI ratio with these tips.

• Pay your revolving debt (credit card balances) down as fast as you can. Zero balances are best, but even lowering your balance slightly can reduce your DTI ratio.
• Cut back on expenses. Think of the bills reported to the credit bureaus and see what you can pay off or cut out of your budget.
• Don’t open new credit accounts. No matter how attractive an account looks or how many rewards a new account offers, don’t open a new account. Think of your overall goals of buying a second home and refrain from opening new credit.
• Refinance your loans. If you have high-interest loans and credit cards, see what you can do to consolidate or refinance them. If you have good credit, you may qualify for a 0% annual percentage rate (APR) balance transfer credit card or an installment loan with a low APR.
• Find ways to supplement your income. Rental income, starting a side gig, or even asking for a raise at your job can increase your income and lower your debt-to-income ratio.

Other Second Home Lending Criteria

The debt-to-income ratio for a second home is one of the largest factors lenders consider, but they look at other factors too including:

• Credit scores of at least 640 – Most lenders allow a score of 640, but you’ll get the best terms and lowest rates with a credit score of 700+.
• Down payment of at least 20% – Second homes pose a higher risk of default so most lenders require at least a 20% down payment, sometimes more.
• Rental income – If you’ll rent the home while its not in use, you may be able to get credit for the projected rental income in your qualifying factors to help you get approved.
• Stable income and employment – Lenders need to know you can afford another mortgage. They’ll look closely at your employment and income history to ensure it’s consistent and stable.
• No recent bankruptcies or foreclosures – Lenders look at your past insolvency history and may require a certain amount of time between a bankruptcy or foreclosure before you can apply for a mortgage on a second home.

Final Thoughts – Debt-to-Income Ratio for a Second Home

Next to your credit score, your debt-to-income ratio for a second home is the most important factor. Lenders use your DTI ratio to ensure you can afford another mortgage. Since a second home isn’t your primary residence, there may be less incentive to keep up with the payments if you’re in financial trouble. You won’t lose a place to live, so lenders realize that you may not work as hard to keep it.

Lenders make up for this risk by ensuring you have a low DTI ratio, good credit score and a healthy down payment. Assess your qualifying factors before applying for a mortgage on a second home to ensure you qualify. 

The post Debt to Income Ratio for Second Home: Follow These Important Guidelines appeared first on Vacation Property Online.

As a real estate investor and owner of a vacation rental property, I’ve dealt with numerous ownership questions first-hand. I’ve also read various resources over the years in order to supplement my own experiences. Yet, there are many different resources out there on various topics, from the true costs of owning a second home to the rules and regulations governing different vacation property types such as waterfront properties. As a result, it’s sometimes hard to get a clear picture of what you should know before buying a second home and what ownership is truly like. With this in mind, I set out to create one resource that provides you with everything you need to know before buying a second home and, in particular, a vacation home.  

I should point out that I use the terms “second home” and “vacation home” interchangeably, mostly because second homes are often bought as vacation homes. Still, if you’re looking to buy a second home for another purpose, such as a part-time residence, investment property or eventual retirement home, the principles discussed in this article will still be relevant. Also, while this article focuses on subjects that are relevant for vacation homeowners in the United States and Canada, most topics will be relevant in other jurisdictions. With this in mind, if you’re wondering whether buying a second home is right for you, then you’ve come to the right place.

For an overview of how to buy a vacation home, explore my article on How to Buy a Vacation Home: A Practical Guide.

Setting the Stage

As you contemplate buying a second home, keep in mind that you will have your own unique set of circumstances, from personal finances to the locations you are interested in. Therefore, you should seek appropriate advice from qualified advisors, including accountants, lawyers and realtors, in your hunt for a second home. I can’t emphasize enough the importance of utilizing each of these experts, who have saved me countless headaches and likely thousands of dollars. Still, based on my own knowledge and experience, this is everything you need to know before buying a second home.

Types of Second Homes/Vacation Properties

As you consider buying a second home, a logical starting point is to consider the various types of properties. First up are the usual suspects in houses, condos, cabins and cottages. 

Houses, condos, cabins and cottages

Each of these property types are fairly well understood so I won’t describe them in detail, other than to highlight what you really need to know for each: 

• House vs. condo. With a vacation house, you’ll have more privacy than a condo but also higher maintenance costs. One of the things I like most about my vacation condo is that it’s fairly hands off. I can leave it vacant for extended periods of time and, other than minimal upkeep, I don’t have to worry about major repairs or landscaping the yard, for instance. It does help, however, to have a proactive and well run strata (or HOA). Still, if you want more privacy and can handle more responsibility and expense, a vacation house may be right for you.
• Cabin vs. cottage. While cabins and cottages differ primarily by the materials used to construct them, I typically consider them one and the same. Sure there may be different maintenance considerations for a log cabin versus a brick cottage, but the premise is the same. Typically a cabin or cottage is located in a more remote location close to nature. Thus, in addition to the considerations above for a vacation house, you’ll need to take into account how remoteness will impact your use and enjoyment.

Waterfront and water-access only

Waterfront properties are unique for many reasons, including the additional regulations that govern such properties and additional maintenance required. They’re in high demand and as a result typically hold their value. But the premium paid for waterfront is not the only relevant consideration as you need to keep the following in mind before buying a second home on the waterfront:

• Home inspections. In addition to the typical items to look out for in a house inspection, corrosion caused by salt in the air and mildew/mold issues from higher moisture levels can all cause damage on a waterfront property. Boundary surveys, elevation certificates and water quality tests can also be important. For instance, how far above the sea level or the lake shore is the house and is the area prone to flooding? In short, be sure to hire qualified home inspectors, surveyors and other experts before buying a waterfront property.  
• Understand what you own. With waterfront property, it is particularly important to review the legal description to determine where the lot extends. Additionally, you will need to determine whether there are any additional encumbrances on title that would otherwise limit your use of, or access to, the waterfront. Whether the property is located in the United States or Canada, it may be worthwhile to run this by a real estate lawyer before buying a second home on the waterfront. 
• Understand the limitations that come with it. Understanding what restrictions come with the property and what you can build on it are particularly important. Governmental regulations on waterfront properties govern such things as site density, minimum building setbacks from the water, the kinds of uses that are permitted, whether you can build a dock or seawall and even building design. In the United States and Canada, you may also need approval from other government departments including the U.S. Army Corps of Engineers and Department of Fisheries and Oceans (in Canada) for work in and around the water.
• Additional maintenance. Not surprisingly, waterfront properties require additional maintenance and expense in order to keep the property in tip-top shape. Potential issues include:
  • Humidity resulting in mold 
  • Corrosion from salt in the air (in the case of oceanfront)
  • High winds causing structural damage 
  • Falling trees in open areas
  • Floods 

In order to combat these issues, consider storm-proofing the house and ensure you have adequate insurance coverage. In short, waterfront properties are expensive to maintain so be prepared to pay double a typical maintenance budget.

• Water-access only. For some, owning your own private piece of paradise is appealing yet the remoteness and/or inaccessibility of water-access only properties may deter some buyers. Obtaining financing for these types of properties can also be difficult. While not for everyone, the general feedback I’ve received from other owners is that water-access only properties are an affordable alternative if you have access to reliable transportation and are willing to forego modern day conveniences. 

Fractional ownership and timeshare

Fractional ownership structures and timeshares are also an affordable option for those interested in dipping their toe into vacation home ownership. I’ve personally never been drawn to these types of properties because I’ve always (a) viewed outright ownership as a better investment and (b) liked to have complete freedom and control in terms of the use of my property. With this in mind, this is what you need to know before buying a second home that falls into one of these categories:

• Fractional ownership.  With partial ownership, several buyers each hold an equal interest in the title to the property. This is different from a timeshare where title to the property is 100% held by you as the principal owner. As an owner of a fractional interest in a vacation home, you’re also often allowed to use the property for a longer duration than a timeshare. From an investment perspective, you may see an increase in the value of your fractional interest over time.
• Timeshare – With a timeshare, your usage rights will vary slightly depending upon the type (e.g. fixed week, floating etc.). You also have no control over the property and they are notoriously hard to sell. Yet, timeshares are quite affordable, there is less responsibility as an owner and you’ll have certainty as to where and when to take your vacations. For these reasons, a timeshare is a lifestyle purchase as opposed to an investment. Importantly, I’ve heard of too many cases of timeshare owners making emotional decisions when buying-in originally so be sure to take some time before buying.

Leasehold

An owner of a leasehold property has an exclusive right to occupy the property for a specified period, in some cases up to 100 years or more. At the end of the lease, the right to occupy the property reverts to the owner. For this reason, leasehold properties are typically more affordable and there are often restrictions with what you can do with the property during the term of the lease. If you’re looking at your second home as an investment property, then I would avoid buying a second home that is a leasehold since you don’t actually own the property and therefore don’t typically enjoy the same upside in price appreciation. 

Different Second Home Uses

In addition to buying a second home for vacation purposes as a “home away from home”, there are many different reasons to buy a second home. Here are a few insights I’ve learned over the years about these other specific uses:

Vacation home vs second home vs investment property

I find there is a lot of confusion as to the difference between a vacation home, a second home and an investment property and the implications of each. Importantly, the designation of your property can have implications on your mortgage terms and tax treatment. While I encourage everyone to obtain their own independent tax advice, here are some important things to know:

• Vacation home vs second home. In short, there is no real difference between the two. More specifically, a second home is a residence you intend to occupy for part of the year in addition to your primary residence. Typically, second homes are owned as vacation properties but they could be used for other purposes (such as a condo in the city for work). 
• Second home vs investment property. An investment property differs from a second home in that it is owned primarily for investment purposes, typically through rental income, rather than as a second residence. A vacation rental property is one such example of an investment property, where the primary purpose is to generate income from the property as opposed to using it as a second home. 
• Mortgage implications. Mortgages for second homes will typically be associated with stricter lending criteria and higher interest rates than primary residences. For an investment property, such as a vacation rental, you can expect interest rates to be even higher and even higher down payment requirements, although every lender will have their own lending terms. 
• Tax implications. Depending upon the designation of your vacation home as a secondary residence or revenue-producing investment property, and the thresholds set by the Internal Revenue Service (IRS) and Canada Revenue Agency (CRA), you may be required to report and remit tax on any income derived from your property. Additionally, taxation of capital gains upon the sale of your vacation home is treated differently from a primary residence. 

For a more complete discussion of mortgage terms and tax implications for vacation homes, see below under Vacation Home Financing and Tax Considerations, respectively. 

Owning a vacation rental property

Thanks to the popularity of vacation rental platforms such as Airbnb and VRBO, it’s easier than ever to own and operate a vacation rental property. Yet there are many items to take into account before investing in one, from the tax implications of ownership to how to manage your property. While I speak to tax considerations a little later on, here are some other things you need to know before buying a vacation rental property:

• Short-term rental regulations. Many cities and towns in the US and Canada have restrictions on renting out your property short-term. This can range from a simple requirement to obtain a business license to an outright ban altogether so be sure you understand the local regulations. Rules can change overnight as well so it’s best to invest in those areas that cater to tourists, such as resort municipalities, where vacation rentals are viewed more favorably. 
• Vacation rental platforms. I’ve used multiple platforms over the years and each of them has their strengths and weaknesses. Importantly, it’s never a good idea to rely 100% on one vacation rental platform so I recommend using multiple platforms. I also recommend that you create your own website so that you can (a) take direct bookings through friends and family without having to pay any fees associated with rental platforms and (b) slowly build-up search engine optimization over time in order to show up in Google search results. If you do end up taking direct bookings, ensure you require a sufficient damage deposit and execute a short term rental agreement like the one provided here.
• Property management. When deciding whether to manage the property yourself or hire outside management, it ultimately comes down to your willingness to spend additional time and resources dealing with guests or whether you’re willing to pay someone else to do it. If you decide to hire a property manager, expect to pay between 25% to 30% of the rental fees. My wife and I manage our vacation rental and, in my experience, the biggest issue is finding good, reliable cleaners. If you’re willing to do the cleaning yourself then that’s one less issue to worry about. 
• Cell phone and internet access. This is more of an issue for remote properties, but you’ll need to be able to communicate with your guests and deal with issues as they arise. It’s therefore important to have reliable cell phone reception and internet access. 
• Insurance. This one should be obvious but you’ll need to ensure that your insurance policy adequately covers a vacation rental property. More specifically, be sure to understand the specific terms of your policy. For instance, my policy requires all guests to be 21 years or older so our house rules require it.
• House rules. Speaking of house rules, it’s important to establish house rules for your guests to follow. By doing so, you can minimize damage to your home and otherwise control the guest experience.
• Vacation rental mortgages. In order for your lender to properly assess the risk profile of your loan it will need to understand the proposed use of the property. Accordingly, be sure your lender is aware that you intend on renting out your property when you submit your loan application.

Owning a family vacation home

Dealing with family dynamics can be difficult when it comes to managing a vacation home that is shared by multiple family members. Establishing house rules and splitting up the time equitably between family members are each important. Having a proper exit strategy is also particularly important in case things don’t work out as planned or one of the family members experiences unexpected financial hardship. Before buying a vacation home with a family member, consider whether ownership as tenants in common makes more sense than joint tenants. With a tenancy in common, each family member may control an equal or different percentage of the vacation home and has the right to leave their share of the property to any beneficiary. This provides more flexibility than joint tenancy where, upon the death of an owner, title passes to the surviving owner. Note, however, that if there is a mortgage on the property, typically all borrowers sign the mortgage documentation meaning that if there is a default the lender may realize the debt on all family members.

Owning a weekend home

With a weekend home, the property will be vacant during the week when not in use, perhaps even over the winter months entirely. With this in mind, here is what you need to know:

• Costs vs benefits. With all vacation homes, and weekend homes in particular, you’ll need to ask yourself how much you can reasonably expect to use the property? In particular, ask yourself whether it makes more financial sense to rent versus own a place in your desired area. If you can regularly rent something for a reasonable price, then perhaps it makes more sense to rent instead of own.
• Travel time. Personally, I’ve always steered away from trips that are 3 hours or more unless I am planning on staying there for three or more days. Ideally, your total travel time will be under two hours if your vacation home will be used primarily for weekend use. Otherwise I just find that you spend too much time travelling to your destination as opposed to actually enjoying it. For other travel time guidelines, I find these rules of thumb useful. 
• Secure storage. If you want to avoid packing, securing and transporting all of your gear every weekend, such as a boat, ATV, paddleboard, kayak or canoe, I recommend having secure storage on site where these items can be permanently stored. 

Second Home Financing

Securing sufficient financing to buy a second home, with reasonable terms, may be the most important consideration for many would-be second homeowners. As mentioned earlier, mortgages for second homes will typically be associated with stricter lending criteria and higher interest rates than primary residences. For vacation rental properties, you can expect interest rates to be even higher in addition to even higher down payment requirements. For reference, even though I have a strong credit history, consistent income and sufficient savings for a 20% down payment, only one of the Big Five Banks in Canada was willing to lend to me when I purchased my vacation rental property and my mortgage was about 75 basis points higher than a mortgage for a primary residence. The reality is that there are fewer lenders willing to lend you money to buy a vacation rental, and those that do require a higher interest rate due to the increased risk profile.

Curious to know about how much you can afford in a second home? Be sure to explore this second home affordability calculator.

Based on my own experience, and the stated policies of major banks in the US and Canada, here is what you need to know:

• Credit score.  A credit score of 700 or more will increase your chances of approval, however a minimum of 640 is typically required.
• Interest rates. Expect interest rates to be as much as 0.25% – 0.5% higher than primary residence interest rates. For a vacation rental property, you can expect interest rates to be even higher (e.g. 50 to 75 basis points). With today’s low interest rate environment, however, it’s a great time to get affordable vacation home financing.
• Down payment. Expect to pay between 20% – 30% as a down payment. To lower the risk of default, lenders require higher down payments.
• Maximum debt-to-income ratio. Your debt-to-income ratio should be no more than 43% overall. Your debt-to-income ratio is the percentage of your gross monthly income that goes to paying your monthly debt. This includes the mortgage on your primary residence, the new mortgage on your vacation home and any other outstanding debts. 
• Distance from primary residence. In the United States, if you want to take advantage of the more beneficial lending terms (e.g. lower interest rate) associated with second homes as opposed to investment properties, your second home must typically be at least 50 miles away from your primary residence. Otherwise, your second home may be viewed as an investment property in the eyes of a lender. In Canada, the distance from your home will similarly be taken into account as to whether you truly intend to use the home as a secondary residence or an investment property.

Some of the best ways to finance a second home include:

• Second home mortgage. This is the same as a traditional mortgage except that a second home mortgage will exist over, and be secured against, your second home as opposed to your primary residence. 
• Home equity line of credit. A HELOC acts much like a credit card in that you can borrow up to a certain limit and are only required to pay interest on the amount actually borrowed. In order to be eligible, you will need to have equity available in your existing home. Depending upon the lender, you may be able to utilize up to 80% of the equity in your home (or lower in the case of federal financial institutions in Canada), assuming there is no outstanding mortgage or other loan secured against your home.
• Second mortgage. A second mortgage is just that – a second mortgage over your primary residence. These are riskier from a lender’s perspective as the lender will be in second position to the first lender should you default. 
• Cash-out refinance. With a cash-out refinance, you cancel your existing mortgage and enter into a new mortgage with a larger amount than owed on the previous mortgage. You can then use the extra cash to buy a vacation home.
• Private lenders. If traditional banks won’t lend you money, then you may be able to obtain financing from private lenders such as friends, family, a private investor or even peer-to-peer online lending. Just be aware that private lenders typically charge higher interest rates and/or other fees given the heightened risk in lending to someone that the banks won’t.  

True Cost of Owning a Second Home

Before buying a second home, it’s important to understand the true cost of ownership in order to ensure you can afford the carrying costs. In my experience, people tend to underestimate ownership costs so you can expect your monthly bill to be higher. To begin with, let’s look at my own example.

For an accurate estimate of your monthly ownership costs, be sure to explore this cost of owning a vacation home calculator. 

Vacation Home Cost Example

As an example, here is a breakdown of the one-time costs and ongoing carrying costs of my vacation rental property (all in Canadian dollars), which was purchased for $715,000 at the beginning of 2019 and was partially furnished:

• One-time costs:
  • Down payment: $143,000 (20% of purchase price)
  • Property transfer taxes: $12,300
  • Conveyancing fees and disbursements (legal): $1,630.87
  • Minor renovations and furnishings: $4,743.41
  • Special assessment in Fall of 2019: $4,029.75
• Recurring costs (monthly):
  • Mortgage: $2,898.26
  • Property taxes: $246.96 ($2,963.52 annually)
  • Insurance: $70 ($840 annually)  
  • Utilities: $40
  • Cable, internet and streaming services: $122
  • Maintenance and repairs: nil 
  • Ongoing accounting and legal fees: $41.67 ($500 annually)
  • Strata fees: $557.83

Based on the above, my monthly carrying costs are $3,976.72 but I would expect that number to be slightly higher after factoring in additional nominal costs not reflected above. If I add the one-time costs (e.g. property transfer taxes, furnishings, special assessment etc.) and spread them out over the 2.5 years I have owned my home, my monthly carrying costs have been roughly $4,733.52 over that period. Further, while I have not yet spent any material amount on repairs and maintenance, I expect this will catch up to me soon and that my spending will be in line with a more typical allocation of between 1% – 4% of my home’s value being spent annually on maintenance.

Other costs that may be relevant depending upon the circumstances and location of your property include:

• HOA or resort fees
• Vacancy, general excise and other taxes (location/use specific)
• Management, cleaning and other vacation rental ownership fees

Despite your best efforts to plan for everything, I can attest to the fact that unexpected costs arise from time to time. If it’s not a special assessment from your condo association, then it will be your hot water tank or furnace that will give out. As such, keep some cash available for these unexpected costs. 

Opportunity Cost

Perhaps one of the most overlooked costs is opportunity cost, or the forgone benefit that would have been obtained from the next best alternative. This is not easy to calculate in every instance but I recommend trying this real estate ROI calculator. It’s a simple calculator that shows the expected return on investment (ROI) from your second home over the life of the mortgage and, for comparison purposes, the ROI should you instead choose to invest in the stock market over that same period. A little later on I will explore my own expected ROI from my vacation rental property and compare it against a stock market investment. In the meantime, let’s move on.  

Second Home Maintenance

As I’ve already covered off the principal costs associated with owning a second home, I won’t explore maintenance costs any further. I will, however, provide the following insight into second home maintenance generally:

• Less may be more. The more stuff you have in your home, the more that can go wrong. While AC units and hot tubs are nice to have, consider whether it’s necessary to have them in your second home. If not, you may be better off without them. 
• Prolonged vacancy. If your home will remain vacant for long periods, consider hiring someone to check on the property. In fact, you may not have insurance coverage if your home is left empty for 30 or 60 days, depending on the policy. By having someone check on your property every 30 days, you can typically satisfy the minimum requirements under your insurance policy. 
• Install a security system with remote monitoring. Consider installing a security system with remote monitoring to reduce risk of vandalism or theft. With smart video cameras, you also have the ability to keep tabs on your property in case of unexpected events such as a flood caused by bursting pipes or an electrical fire. 
• Winterizing. Simple steps to winterize your property will keep the cold out, the heat in and your energy bill down. Steps like flushing the water heater, adding window insulation film and adding draft guards under doors will all help and with only minor expense.   
• Storm proofing. If your second home is in an area that is prone to storms, you will save yourself a lot of headache by storm-proofing the house as much as possible. Adding storm shutters, trimming trees away from the house and removing clutter from around the yard are simple things you can do. Larger projects, such as structural upgrades, may be necessary and will require hiring qualified help.

Second Home Tax Considerations

First, a word of caution. Tax rules are complex and everyone’s circumstances are different. Accordingly, you should consult a qualified tax adviser in connection with your own tax planning. 

As you consider buying a second home, it’s important to understand the tax consequences of ownership. The two most significant tax implications of ownership are typically (i) taxation of revenue derived from your property and (ii) taxation upon the sale of your property. Let’s take a closer look at each.

Taxation of Rental Income

In both the United States and Canada, the IRS and CRA, respectively, will have an interest in any commercial activities associated with the property and, in particular, rental income. Thus, you will need to give adequate consideration to the tax consequences of renting out your second home.

In the United States, if you rent out your property for 15 days or more, then the IRS may view your property as a rental property. As a result, you will be required to report any rental income and pay appropriate tax. One of the benefits of operating a rental property, however, is that you can deduct various expenses, including property taxes, insurance premiums, condo fees, utilities, mortgage interest and depreciation. These deductions can then be used to offset a portion of the rental income, thus reducing your tax burden. Note, however, that if you also use your rental property as a residence, limitations may apply to the expenses you can deduct. According to the IRS, you’re considered to use a dwelling unit as a residence if you use it for personal purposes during the tax year for more than the greater of: (i) 14 days, or (ii) 10% of the total days you rent it to others at a fair rental price. An accountant with experience in this area will be able to advise you as to which expenses you can deduct based on your individual circumstances.

In Canada, if you rent out your property then you will similarly be required to report any rental income and pay tax on it. As an owner of a short-term vacation rental property, an important threshold to keep in mind is the annual revenue limit of C$30,000. If you exceed that limit over four consecutive quarters, you will be required to charge and remit GST/HST on any rental income. Keep in mind that, similar to the US, you’re also able to deduct appropriate expenses from any rental income to reduce your tax burden. 

Whether you’re located in the US or Canada, be sure to retain accurate records of the rental income you’ve received and all of the expenses claimed on your tax return in case you’re ever audited. The retention period is three years in the US and six years in Canada.  

Taxation Upon the Sale of Your Second Home

In the United States, if you have held your second home for more than one year, any profit on the sale will be taxed as long-term capital gains. Notably, tax rates for long-term capital gains are more favorable at 15% or 20% (to the extent that your taxable income exceeds the thresholds set for the 15% rate). Prior to selling your second home, you may want to consider the taxable exclusion of $250,000 ($500,000 if married filing jointly) in gains from sales of a primary residence. To qualify, you would need to treat your second home as a primary residence for at least two of the last five years prior to selling. Note, however, that a reduction is made on a pro rata basis to reflect the period of rental, vacation home or other “non-qualifying use”. Also, keep in mind the IRS’ rules on depreciation recapture tax upon the sale of a rental property. This occurs as a result of a taxpayer deducting the depreciation of a rental property from the taxpayer’s ordinary income. The taxpayer has to report any gain from the disposal of the rental property (up to the recomputed basis) as ordinary income.

In Canada, when you sell your second home any gain will be subject to taxation. This differs from the gain realized from the sale of your primary residence, which is tax-free. If you have not claimed any depreciation expense (or “capital cost allowance”), you will realize a capital gain or loss on the sale. If the sale price is more than your cost, one-half of the capital gain is included in your taxable income. If you claimed capital cost allowance, then selling the property may result in a recapture of your capital cost allowance. When you change your principal residence to a second home or rental property (or change your second home/rental property to your principal residence), it’s called a change in use for tax purposes and the CRA may treat it as if you sold the property. For a principal residence, you don’t have to pay tax on any capital gain up to the point of conversion to a second home. For a second home, any gain accruing up to the point of conversion to a principal residence is taxable. Lastly, if you’re collecting GST/HST as an operator of a short-term rental property, you are required to collect GST/HST on the sale of your property.

Pros and Cons of Owning a Second Home

Any discussion about buying a second home would not be complete without considering the pros and cons of owning a second home. With this in mind, here is my list of the pros and cons of owning a second home:

Pros

• Relatively secure investment. Real estate prices in the United States and Canada tend to go up over time and have not experienced the same volatility as other asset classes. 
• Additional ways to increase ROI. By owning a vacation home, you have the ability to maximize your return on investment through home renovations and/or rental income when the home is not in use (but be mindful of the tax implications).
• Borrowing is cheap. Given the low interest rate environment, borrowing money to buy a second home is cheap (assuming you meet the stricter lending criteria). Because of this, you can build wealth using the bank’s ‘cheap’ money.
• Hosting friends and family. Owning a vacation home is a great way to bring family and friends together as there will be no shortage of visitors.
• Retirement. What better way to plan for retirement than owning a second home as an eventual retirement home?
• Pride of ownership. Speaking from personal experience, one of the best things about owning a vacation home is the joy it brings. Quite frankly, this is often the biggest reason to buy a vacation home.

Cons

• Real estate historically outperformed by stock market. If you’re buying a second home for investment purposes, it’s worth noting that real estate in the United States and Canada has historically been outperformed by the stock market. 
• Lack of diversification. Spending further money on real estate may be risky, especially if you’re not well diversified in other asset classes. 
• Ownership isn’t passive. Unlike owning stocks, owning a second home isn’t passive as it will require ongoing time and commitment, from paying annual property taxes to renewing your insurance.  
• Ownership costs. The expenses can pile up pretty quickly as your second home will require ongoing repairs and maintenance.
• Usage may be less than you expect. This will certainly vary from owner to owner but you may find that you don’t actually use your property as much as you expect. I have historically only used my property roughly two weeks a year but then again I’m also operating a vacation rental property. 
• Vacation home moochers. While hosting friends and family is one of the benefits of owning a vacation home, you may also have to deal with freeloaders looking for a free stay.

Is Buying a Second Home Worth it?

With the above in mind, is buying a second home worth it? As mentioned previously, this real estate ROI calculator enables you to directly compare how a real estate investment will perform (with or without rental income) against a stock market investment. Let’s consider some return on investment scenarios using my own example:

• Vacation home purchase price: $715,000
• Down payment: $143,000
• Mortgage terms: 3.61% interest rate with a 25 year amortization schedule
• Monthly rental income: $5,000
• Aggregate monthly expenses: $2,000

Based on the above assumptions, the real estate ROI calculator shows that I’m netting an extra $102.58 per month in rental income, which would not be available if I instead chose to invest in the stock market. Therefore, I need to compare the value of my vacation home plus $102.58 in monthly rental income after 25 years against investing $143,000 (i.e. the size of the down payment) in the stock market over that same period with no additional contributions. Here’s what it shows under the following scenarios:

Scenario 1: Vacation Home Appreciates 4% Annually and Stock Market Grows 8% Annually

• Value of vacation home (and net rental income) at end of term: $1,971,116.09
• Value of stock market investment at end of term: $1,049,645.16

Scenario 2: Vacation Home Appreciates 4% Annually and Stock Market Grows 6% Annually

• Value of vacation home (and net rental income) at end of term: $1,971,116.09
• Value of stock market investment at end of term: $638,490.68

Scenario 3: Vacation Home Appreciates 2% Annually and Stock Market Grows 8% Annually

• Value of vacation home (and net rental income) at end of term: $1,209,119.17
• Value of stock market investment at end of term: $1,049,645.16

As you can see, I’m better off buying a second home in each of the above scenarios. Of course, the above doesn’t take into account appropriate tax planning strategies. For instance, by utilizing a tax sheltered account such as a 401K plan in the United States or RRSP/TFSA account in Canada, you may be able to shelter some or all of the tax burden of a stock market investment. All of the sudden investing in the stock market doesn’t look so bad, especially if you can’t claim a primary residence tax exemption under the vacation home scenario. The other difficulty is that not all of the benefits or drawbacks of buying a second home can be objectively measured. After all, you can’t put a price on the time spent with the kids (or grandkids) and the lifelong memories that result. On the flip side, it’s hard to quantify or value the additional time spent maintaining your property. Personally, I’m very happy with my vacation home. From the revenue it generates as a vacation rental to the joy it brings me and my family, I expect to hold onto it for many years, and ski trips, to come. 

With that, I encourage you to consider each of the items noted above in this article before buying a second home. This is certainly everything I wish I knew before buying my vacation home.

About the Author

Peter is a father, entrepreneur and real estate investor. Together with his wife, he owns and operates a vacation rental property in Whistler, BC and is eager to pass along his knowledge and personal experience.

The post Buying a Second Home: Everything You Need to Know Beforehand appeared first on Vacation Property Online.

A second mortgage is an additional loan taken out on a property that’s already mortgaged. If you have equity built up, a second mortgage is a great way to have money to buy a vacation home in the US or Canada. 

If you’re like most people you may wonder how to qualify for a second mortgage. Keep reading to learn how.

The Different Types of Second Mortgages

Just like when you applied for your first mortgage, you must qualify for a second mortgage. It’s not as hard as it seems, but first, you must understand your options.

• HELOC – A home equity line of credit is a credit line against your home’s equity. Like a credit card, you’re issued a credit line you can leave or use. If you use it, you make interest payments on the amount withdrawn and can choose to pay principal or not. The interest rate is variable and could change often.
  • In the US, you can use funds during the ‘draw period’ which lasts three to ten years. After the draw period, you enter repayment. During this time you pay principal and interest on any outstanding balance until it’s paid off, for a total term of up to 30 years (10 in the draw period and 20 in repayment).
  • In Canada, most HELOCs have an indefinite term where you can either make interest-only payments or also repay the principal whenever you like without any prepayment penalties.
• Home equity loan – This is a second mortgage on a house. You receive your funds as one lump sum and make principal and interest payments right away. Unlike with a HELOC, the interest rate is fixed, so you have predictable payments each month, but cannot ‘redraw’ funds as it’s a closed-end mortgage.
• Cash-out refinance – A cash-out refinance isn’t technically a second mortgage. Instead, it combines the benefit of a second mortgage with the first. To qualify, you must pay off your first mortgage with the new loan, but instead of borrowing the same amount as your outstanding principal, you’ll tap into your home’s equity. A cash-out refinance has one payment and can have a fixed or adjustable interest rate, depending on what you prefer and/or the lender will approve. You receive the difference between the new loan amount and your first mortgage payoff in hand to use as you want.

When comparing how to qualify for a second mortgage, a second mortgage has tougher qualifying requirements because the second mortgage lender takes second lien position. This means they have less of a claim to the property than the first mortgage lender.

Where Can You Get Second Mortgages?

Second mortgages are available from the same banks you can get your first mortgage. Popular places are major banks, mortgage lenders, mortgage brokers, trust companies, and private lenders. 

If you have ‘weaker’ qualifying criteria, focus your efforts on private lenders or trust companies. They typically have more flexible guidelines than traditional banks. This is especially important if you’re worried about how much can I get approved for a second mortgage? Private lenders and trust companies are more lenient in their offering.

How to Qualify for a Second Mortgage

It’s important to realize second mortgages have higher interest rates due to the risk. Second mortgage lenders are in second lien position. If you default on your loan, the first lienholder gets paid first. If there are tax liens on the home, those get paid out even before the first mortgage company.

This often leaves second mortgage lenders with little to no proceeds. To compensate for this risk, second mortgage lenders charge higher rates. To keep your rate to a minimum, you’ll need to know how to qualify for a second mortgage. Here are general rules of thumb:

• Minimum 640 credit score, but a score over 700 will increase your chances and decrease your interest rate
• Maximum debt-to-income ratio of 43% (your total monthly debts shouldn’t exceed 43% of your gross monthly income or income before taxes)
• Strong history of stable income and employment
• Leave at least 15%, but up to 25% equity in the home untouched

If you don’t meet the above guidelines, don’t worry, trust companies and private lenders may offer more relaxed guidelines, allowing you to secure a second mortgage, but watch the interest rate to ensure it makes sense to borrow the funds.

How Much Can You Get Approved for a Second Mortgage? 

Everyone wants to know, how much can I get approved for a second mortgage? Just like a first mortgage, it differs. In the United States, for example, you may borrow up to 85% of the home’s value (less the amount you owe on your first mortgage) from some lenders if you have great qualifying factors. Others may restrict you to 80% of such value. In Canada, most lenders restrict your borrowing capacity to 80% of the home’s value (less the amount you owe on your first mortgage), although lower limits exist for HELOC loans with federal financial institutions.

Keep in mind, the maximum borrowing limit includes your first mortgage. For example, if your home is worth $350,000 and your first mortgage has a balance of $175,000, in the US you may be able to borrow up to $122,500 (85% of $350,000 less outstanding mortgage of $175,000) and in Canada up to $105,000 (80% of $350,000 less outstanding mortgage of $175,000).

A down payment of this size could increase your chances of securing an affordable mortgage to buy a second home in the United States, Canada or elsewhere. A substantial down payment helps offset the risk of default on a home that isn’t your primary residence. Therefore, your application is more desirable in the eyes of a lender.

How to Increase Your Chances of Second Mortgage Approval

If you wonder how to qualify for a second mortgage, here are some tips to help increase your chances of approval.

• Establish a strong credit history. Pay your bills on time and keep your credit card debts low to keep your credit score high.
• Reduce your debt-to-income ratio. Keeping your debts low will increase your chances of approval. Either pay your balances down or increase your income by taking on a side gig or part-time job.
• Reduce excess credit limits. Further to the above, if you have unused credit cards you may want to consider getting rid of them or reducing the limits. This is because a lender will consider any credit cards to be drawn to their full limit. For example, if you have two credit cards, each with a $10,000 limit, a lender will write down $20,000 in debt against you.
• Stabilize your employment and income. Try keeping the same job for at least 2 years and show stable income to reduce your risk of default.
• Keep a solid mortgage payment history. Second mortgage lenders will focus on your mortgage payment history, and if you have any late housing payments it could hurt your chances of approval.

Final Thoughts – How to Qualify for a Second Mortgage

While it’s a little tougher to qualify for a second mortgage, it’s not impossible. With a little preparation and good personal financial choices, you can borrow against your home’s equity to buy the perfect vacation home.

Curious to know how much you can afford in a second home? Be sure to explore our article on how much second home you can afford as well as our vacation home affordability calculator. 

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