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 The money in a 401(k) grows tax-free until withdrawn, at which time the account holder will pay income tax on the money taken out.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advantages are similar to a 401(k) where contributions reduce your taxable income and the money grows tax-free until withdrawn.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 With a traditional IRA, your contributions reduce your taxable income but you pay tax when the money is withdrawn. Alternatively, with a Roth IRA taxes are paid on the contributions themselves, but the money can be withdrawn tax-free at retirement.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 Once withdrawn, tax is payable thereby permitting you to defer taxes until retirement.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.

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.

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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.

You have more options than most people think including a traditional mortgage, of course, but there are several other options that may open up your opportunity to buy a vacation home.

Check out how to finance a vacation home below and see just how easy it is.

Before buying a vacation home, be sure to also explore our article on How to Buy a Vacation Home: A Practical Guide.

Traditional Mortgage

Just like when you bought your primary residence, you can secure a traditional mortgage to buy a vacation home. Most lenders have stricter lending criteria when you buy a home other than a primary residence because the risk of default is higher.

This doesn’t make it impossible to secure vacation home financing, though. Knowing ahead of time the requirements you’re up against will help you ensure you qualify. Here’s what you must know:

• Interest rates can be as much as 0.25% – 0.5% higher than primary residence interest rates. Today’s low interest rate environment, though, makes it a great time to get affordable vacation home financing.
• You’ll likely need a 20% – 30% down payment. To lower the risk of default, lenders require higher down payments. The more money you invest in the home, the less likely you are to default.
• Your maximum debt-to-income ratio should be 43%. This includes the mortgage on your current home, the new mortgage on the vacation home, and any other outstanding debts you carry.
• For borrowers in the United States, the property must typically be at least 50 miles away from your primary residence in order to enjoy the “second home” classification that is coupled with a lower interest rate. For borrowers in Canada, the distance between your primary home and vacation home may similarly be relevant to lenders for the purposes of determining whether you truly intend to use your home for vacation or investment purposes.
• If you rent the property out when you aren’t using it, your bank may classify it as a rental property. Investment properties have tougher restrictions and higher interest rates, so make sure you’re clear on what/how you’ll use the property.
• If you use the property as a rental, you may be able to use up to 75% of the rental income (fair market rent for the area) as income to help you qualify.

Home Equity Line of Credit

If you don’t want a traditional mortgage, you can leverage the equity in your primary residence when deciding how to pay for a vacation home. For this method to work, you must have equity in your home. Most lenders allow you to tap into up to 80% of the home’s value less the amount you owe on your first mortgage (although HELOC loans with federal financial institutions in Canada are limited to 65% of the home’s value). The difference between 80% of your home’s value and your current mortgage balance is the money you can use to buy your vacation home.

HELOC loans have many benefits including:

• Interest-only payments are all that’s required. You only pay interest on the money you withdrew too. For example, if you took out a line worth $150,000, but you only used $100,000, you pay interest on $100,000, not $150,000. After a certain period of time, however (e.g. ten years) you may owe regular principal and interest payments.
• HELOC loans have less strict guidelines than vacation home loans. If you have decent credit and an average debt-to-income ratio, your chances of approval are high.
• HELOC loans have fewer closing costs than a traditional loan because there’s not as much work involved in underwriting and processing the loan since it’s on a property you already own.

Many people use HELOC loans to finance properties that would be difficult to finance through a traditional mortgage. A few key examples include buying land or remote properties that have no comparable sales making lenders wary of lending on them.

Second Mortgage

A second mortgage is another way to leverage the equity in your primary residence. This is often the best way to use the investment you’ve built in your residence. A second mortgage is a fixed loan, much like your first loan. You pay principal and interest payments on a fixed term, just like your first mortgage.

Most lenders allow you to borrow up to 80% of the home’s value on a second mortgage, just like the first mortgage, if you’re taking the cash out to pay for a vacation property.

The underwriting requirements are a bit tougher than a HELOC because you receive the funds in one lump sum at the closing. You can use the funds for the down payment or to pay for the home ‘in cash’ if you have enough equity.

Private Lenders

If you don’t qualify for any of the traditional mortgage options above when deciding how to finance a vacation home, private lenders may be your best option.

Private lenders could be anyone – friends, family, a private investor, or even peer-to-peer lending online. Private lenders set the requirements including the interest rate and term. They’ll assess your qualifications much like a bank would, but based on their own terms, so it’s usually much easier to qualify.

Private lenders usually charge much higher interest rates and/or fees because they’re taking a large risk lending to you. They are investing their capital in you versus investing in the stock market or any other asset. They expect a high return on their investment in exchange for the benefit they’re offering you.

Cash

Of course, there’s always the option to pay in cash. If you liquidate assets (sell stocks or another home, for example), you can invest the money in your vacation home. While it may feel like a big leap to spend hundreds of thousands of dollars on a home in cash, it’s an investment.

Since homes appreciate, you’re investing your money, letting it grow, while providing you and your family with the luxury of owning a vacation home to enjoy.

Final Thoughts – How to Finance a Vacation Home

Knowing how to finance a vacation home is one of the most important considerations in the process. Be sure to explore your financing options to determine how to pay for a vacation home and make your family’s dreams come true. Once financing is arranged, you can then proceed with the next steps to buy a vacation home.

If you’re curious as to how much you can afford towards a vacation home, explore our calculators here.

The post How to Finance and Pay for a Vacation Home appeared first on Vacation Property Online.

But mortgage rates are typically higher for vacation homes for one good reason – risk. Lenders view a home you don’t live in full-time as risky. You don’t have as much to lose if you default on a vacation home as you do if you default on your primary home. You’ll still have a place to live, but the bank would be out their money.
So, how much higher are vacation home interest rates, and what do you need to know? Check out our guide below on vacation home interest rates.

What rate can you expect?

Of course, everyone wants to know – what’s the rate? While every situation differs based on the property, your qualifying factors, and the market, you can expect to pay rates that are 0.25% to 0.5% higher than you would for a primary residence.

Today’s interest rates are still low, making it a great time to buy a vacation home. On average, primary homeowners pay 2.875% – 3.0% in the United States (according to the posted rates of the “Big 4 Banks”) and 2.34% – 2.65% in Canada (according to the posted rates of the “Big 5 Banks”). For more information on these rates, click on the following links:

• US Banks: JPMorgan Chase, Bank of America, Citigroup and Wells Fargo
  
• Canadian Banks: Bank of Montreal, Scotiabank, Canadian Imperial Bank of Commerce, Royal Bank of Canada, Toronto-Dominion Bank

Based on these average rates (using today’s rates), vacation homebuyers can likely expect to pay 3.125% – 3.5% in the US and 2.59% – 3.15% in Canada.

How do you secure the best rate?

The rates above are estimates – the actual rate you’ll receive depends on your qualifying factors. Because vacation homes have higher risks, lenders often charge higher vacation home interest rates, but to keep your rate down, do the following:

Improve your credit score

Pull your credit (free copies for US borrowers here and Canadian borrowers here) and see what you can improve on. Do you have late payments? Bring them current. Did you overextend your credit cards (that charge more than 30%)? Pay the balances down. Also, don’t apply for any new credit between now and when you want to apply for a vacation home loan.

Keep your debt-to-income ratio low

Your debt-to-income ratio tells lenders how much you can afford based on your current debts. The lower your DTI, the more mortgage you can afford. The lower you keep your debts, the higher your chance of securing the lowest interest rates.

Shop around

No matter your qualifying factors, it’s always important to shop around for the best vacation home mortgage rate. The rates mentioned above are for illustrative purposes, and are the best rates a lender may offer, but only to those with great qualifying factors.

What are some of the vacation home lending criteria?

Every lender differs in their requirements, but you’ll likely need to meet these requirements to qualify for a vacation home loan.

• At least a 640-credit score – Vacation home lenders require higher credit scores to ensure that you won’t default on the loan. Many lenders require at least a 640-credit score, but some require even higher scores. The higher your score, the lower your risk of default and the higher your chance of approval.
• 20% or higher down payment – Most lenders require a 20% – 30% down payment on a vacation home. The higher down payment reassures lenders that you’ll make your payments on time, so that you don’t risk losing the thousands of dollars you invested in the home.
• Debt-to-income ratios of 43% or less – Your debt-to-income ratio tells lenders how much debt you have outstanding compared to your monthly income. They use this number to determine if you’re an acceptable risk and how much they should (or shouldn’t) adjust your vacation home mortgage rate to account for the risk. For more information on how to calculate your debt-to-income ratio, click here.

Alternatives to second home mortgage

If you don’t want to pay higher vacation home interest rates, there are alternatives to secure financing to buy your dream vacation home.

• Second mortgage on your primary residence – If you have equity in your primary home (the difference between the home’s value and what you owe), you can use it to buy another home. You’ll need to take out a second mortgage or do a cash-out refinance on your first mortgage to get the cash, but you can use it as a down payment on your vacation home.
• Home equity line of credit – Similar to the above, if you have equity in your home but want a flexible second mortgage, a HELOC is a good option. It works like a credit card, giving you a credit line equal to the amount you can borrow. You owe interest only on the amount withdrawn (used). After a certain period of time, however (e.g. ten years) you may owe regular principal and interest payments. This can be a good way to get money for the down payment on a vacation home.
• Reverse mortgage – If you’re 62-years or older in the United States or 55 years or older in Canada (both you and your co-borrower) and you don’t have a first mortgage on it, you can use your home’s equity to buy a vacation home. Many retirees do this to enjoy their golden years in another home without taking out a mortgage. Reverse mortgages don’t require repayment until the owner moves or passes away.

Other considerations

If you plan to rent out your vacation home while you’re not using it, you may be able to use the projected rental income in with your income to secure a mortgage. This may increase your borrowing capacity (allowing you to borrow more) or allow lenders to give you a lower vacation home mortgage rate if it decreases your debt-to-income ratio or serves as a compensating factor.

Overall, a vacation home is a higher risk for lenders, which means you must illustrate that you aren’t a high risk of default. If you’re curious about how much you can afford on a vacation home mortgage or what it would cost you, use this vacation home mortgage calculator to see where you stand.

The post Vacation Home Mortgage Rate: What is the Interest Rate on a Vacation Home? appeared first on Vacation Property Online.

 General Requirements

While certain lenders may require a down payment of only 5% for a primary residence, many lenders in the United States and Canada will require a down payment of at least 20% for a second home. This is because second homes are inherently more risky as borrowers are more likely to default on repaying the mortgage on their second home. After all, borrowers faced with financial hardship will typically prioritize repayment of a mortgage on their primary residence as they need a place to live.

Using 20% as an example, if you’ve managed to save up $50,000, then the maximum vacation home you can afford is $250,000 ($50,000 / 20%) regardless of your overall financial picture. If you’ve managed to save up $100,000, then you can afford a vacation home with a purchase price of up to $500,000.

Yet these are just general rules of thumb and, depending upon the use of the property, there may be certain lenders willing to accept a more modest down payment. In order to provide more specific information, we have included more detailed guidelines for borrowers in the United States and Canada below.

United States Requirements

The size of your down payment will depend, in part, on the type of mortgage you choose. Each mortgage type will have its own guidelines and eligibility criteria to consider. Briefly, the following types of mortgages may be available to you:

• Veterans Affairs (VA) loans – VA direct and VA-backed Veterans home loans are only available to Veterans, service members, and their survivors, typically with no down payment.
• Federal Housing Administration (FHA) Loans – FHA loans are another government sponsored loan program that has been around since 1934, characterized by low down payments (as low as 3.5%), low closing costs and easy credit qualifying. FHA loans, however, are only available for primary residences.
• Conventional Loans – unlike VA and FHA loans, conventional loans are not guaranteed  or insured by a government agency. For conventional loans (and FHA loans), mortgage insurance may be required with a smaller down payment (i.e. less than 20%).

Conventional loans are often available for vacation homes but mortgages for such properties are typically accompanied by larger down payment requirements (at least 20%), higher interest rates and more conservative lending guidelines. If you intend on renting out your vacation home, then a lender may consider it as an “investment property” (as opposed to a “second home”), which tend to have even higher interest rates and down payment requirements (i.e. 25% or more). The reason for this is the risk profile of an investment property as owners may be more willing to walk away from their mortgage payment obligations when faced with financial hardship. To summarize, depending upon how you use your vacation home, expect to save at least 20%-25% of the purchase price as a down payment.

Fore more information on vacation home mortgages from America’s “big four” banks, click on the following:

• JPMorgan Chase
• Bank of America
• Wells Fargo
• Citigroup

Canadian Requirements

In Canada, down payment requirements for primary residences differ depending upon the purchase price of your home. Amounts range from 5% of the purchase price for homes $500,000 or less up to 20% of the purchase price for homes $1 million or more.

The rules also differ for vacation homes, in particular as between vacation homes purchased for personal use versus vacation homes used as a rental property.  As rental properties are often seen as higher risk, more stringent qualifying criteria may apply than if the vacation home is for personal use only. As outlined by National Equity Lending, you may still be able to buy a second home with as little as 5% down with the relevant insurance premium added to the mortgage. With 20% down, most lenders will finance your mortgage as a conventional loan. For rental properties, however, you will likely need at least 20% down and even then you are limited to only a few lenders who are willing to lend to you with no insurance premium added to the mortgage. In order to avoid insurance premiums and open it up to a larger pool of lenders, you will likely need at least 25% down.

Fore more information on vacation home mortgages from Canada’s “big five” banks, click on the following:

• BMO
• CIBC
• RBC
• Scotiabank
• TD

Advantages of a Higher Down Payment

A larger down payment has several advantages, including:

• More borrowing options
• Better interest rates
• Higher initial equity position
• Lower mortgage payments

Simply put, the higher the down payment the more loan options will likely be available to you at more competitive rates. By putting 30% down, for instance, lenders lower their risk profile by allocating some of the risk to you as the borrower. The thinking is that by having more “skin in the game” so to speak, you will be less likely to default on your loan. Also, your mortgage payments will be lower since you will be borrowing less money thereby paying less interest over the life of the loan. Further, if you intend on renting out your property then it will be easier to turn a profit since the cost of servicing your mortgage will be less.

Before deciding on a larger down payment, be sure to use our vacation home mortgage calculator to better understand the monthly costs of servicing your mortgage based on different down payment scenarios. It’s also a good idea to keep some savings left over as you may need funds for necessary maintenance and repairs following your purchase.

For more information on vacation home affordability, be sure you read our article on How Much Vacation Home Can I Afford?

The post Down Payment for Vacation Home: Requirements for Buyers in the United States and Canada appeared first on Vacation Property Online.

As more and more people look to expand their real estate portfolio, the recreational housing market continues to see strong demand in the United States and Canada. For some, a second home may represent a welcome escape from the busy city life. For others, a second home may represent an opportunity to generate a return on investment as a revenue-producing vacation rental or other investment property. Regardless of the motivation, second home sales are on the rise.

For anyone who is considering taking out a mortgage in order to purchase a second home, the interest rate available to you will be an important consideration. Inevitably, the question will arise: are mortgage rates higher for second homes? As this article will show, typically mortgage rates are higher for second homes given the risk profile associated with such properties. Your personal financial situation, however, will also impact the interest rate available to you.

What Interest Rate Can You Expect on a Second Home?

While the available interest rate can vary based on the property type, your financial profile and the local market, amongst other factors, you can expect to pay rates that are 0.25% to 0.5% higher than you would for a primary residence. Therefore, if a bank is offering a 3.0% interest rate on a primary residence, you can expect to pay between 3.25% to 3.5% on a second home mortgage.  Of course, this is just a general rule of thumb so be sure to shop around for the best rate.

To illustrate the difference this makes on monthly payments using different mortgage amounts, we’ve prepared a few examples (all assuming a 25 year amortization period):

• Mortgage amount: $250,000
  • Monthly payment at 3.0%: $1,185.53
  • Monthly payment at 3.5%: $1,251.56
• Mortgage amount: $500,000
  • Monthly payment at 3.0%: $2,371.06
  • Monthly payment at 3.5%: $2,503.12
• Mortgage amount: $750,000
  • Monthly payment at 3.0%: $3,556.58
  • Monthly payment at 3.5%: $3,754.68
• Mortgage amount: $1,000,000
  • Monthly payment at 3.0%: $4,742.11
  • Monthly payment at 3.5%: $5,006.24

Be sure to use our mortgage calculator for more specific calculations. 

Why Are Mortgage Rates Higher For Second Homes? 

Interest rates are typically higher for mortgages on second homes when compared to primary residences since lenders view these purchases as being inherently riskier. Unlike a primary residence, a second home is not a necessity. If the owner of the property goes into financial distress, chances are that this property will be the first asset to go into default. Lenders realize this and therefore often charge a higher rate given the heightened risk profile.

Due to the increased risk of default, mortgages on second homes typically have stricter lending criteria, higher interest rates and larger down payment requirements. Banks will take a close look at your credit score, income and outstanding debts to ensure you can handle the additional monthly payments (more on this later). For the down payment, while certain lenders may require a down payment of only 5% for a primary residence, many lenders in the United States and Canada will require a down payment of at least 20% for a second home.

How Do Personal Finances Impact Mortgage Rates for Second Homes?

Depending on your lender, credit history and current financial state, you may be able to secure a reasonable second home mortgage rate. You may, however, end up paying a higher rate if you have a poor credit score or your debt to income ratio is less than desirable. Your debt-to-income ratio is the percentage of your gross monthly income that goes to paying your monthly debt payments (total monthly debt payments divided by gross monthly income). 

So what credit score and debt to income ratio should you strive for? A credit score of 700 or more is where you can expect to pay the lowest rates both in the United States and Canada. It’s recommended that homeowners avoid going over 36% of their gross income when factoring in total debt payments, although some lenders may permit a borrower to have a ratio of up to 43%. Keep in mind that rental income can be used to offset the costs of servicing the mortgage and certain lenders may give you credit for up to 70% to 75% of the fair market rents. 

How Can You Secure the Best Rate

The initial second home mortgage rate quoted by your bank may not necessarily be the best rate. Rather, working with multiple lenders or a reputable mortgage broker will help secure the best possible rate. It’s also important to get your finances in order by having a strong credit history and maintaining a serviceable debt to income ratio.

So are mortgage rates higher for second homes? Typically yes but as this article illustrates there are certain things a homebuyer can do to secure the best rate.

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