A second home can act as both a vacation home and an investment, as homeowners can easily rent them out when they’re not staying there. But like most home purchases, buying a second home probably means you’ll need a second mortgage. When you’re going through the second home search and purchase process, there are a number of factors you’ll need to account for. These include overall affordability, purposes for the home, tax considerations and payment terms. Working with a financial advisor can help you answer questions you may have about buying a second home and how it might affect your financial plans.
1. Can You Truly Afford to Buy a Second Home?
First things first, you’re going to need to make sure you can afford a second mortgage. At this point, you would’ve ideally paid off your first mortgage fully, or at the very least made, consistent, timely payments. Moving forward, there are some new numbers to which you should pay extra attention to.
Second mortgage interest rates on average tend to be about a quarter of a point to a half a point higher than the interest rates on first mortgages. You’ll have to prove to the bank that you can cover both your first and second mortgages with money to spare.
In the days before the Great Recession’s housing crisis, it was easier to leverage a first home purchase to finance a second home. These days, lenders are more conservative when deciding whether to issue loans for secondary homes. In the grand scheme of things, though, the interest on your mortgage is just a part of the overall view of things. Keep in mind that down payments on second mortgages tend to run from 10% to more than 20%.
Aside from weighing the possibility of a second mortgage, consider the costs of utilities, insurance, the cost of travel to and from your second home and maintenance. Some experts estimate you can expect to spend 1% of the purchase price in maintenance expenses per year. Furthermore, you can resort to the “square-foot rule.” This guideline suggests you save $1 for every square foot of the property to cover annual maintenance costs. So if you have a 2,300-square-foot home, you will need $2,300 annually or roughly $192 monthly.
2. A Second Home’s Purpose: Vacation, Rental, Investment
The tax implications are vastly different when you’re renting out your old home, as opposed to keeping it as one of two personal residences. If you go with the latter, the interest on your second mortgage is tax deductible. But, if you’re renting out your first home and generating business income from it for 14 or more days per year, you won’t be eligible to deduct all of the mortgage interest on that second home. You can, however, deduct expenses related to the upkeep of the property during the days tenants occupy it each year.
With that said, there are a number of elements that go into being a landlord. In addition to complying with local landlord laws, you could face other potential headaches. You also may have to respond to a water leak or frozen pipe in the middle of the night. Of course, there are inherent expenses related to these situations.
Of course, you can hire a management company to cover this while you kick back and relax. The price you pay for this comfort could be steep, though. A financial advisor who’s versed in home costs and mortgages can help you figure out if this venture is profitable or not.
If you’re considering a second home strictly as an investment, keep in mind that lenders may call for down payments of 25% or so and also prefer higher credit scores. Generally, government-backed lending programs can’t be used to buy investment property. On the positive side, owners can claim expenditures for mortgage interest, property taxes, insurance, maintenance, utilities and losses due to damage. They can also deduct a percentage of the property’s value each year due to depreciation.
3. Join Forces With a Real Estate Agent
Scoring a second mortgage may be more difficult than obtaining one since you may have significant new debt if you haven’t paid off your first mortgage. A good real estate agent in your area can help you run the numbers to give you an estimate of what you can expect.
It’s not impossible to get a loan with a lower credit score. But on average, a credit score of around 725 to 750 is expected from applicants for second mortgages. The exact credit score minimum depends on the individual lender, however.
In general, lenders don’t want your debt (including a second mortgage) to reach higher than 36% of your monthly income before taxes. This is what accounts for your personal debt-to-income (DTI) ratio.
The process doesn’t end when you sign off on a new mortgage. Our closing costs calculator can give you a better glimpse of what to expect when you seal the deal.
Furthermore, a good real estate agent can offer crucial insight into factors like neighborhood safety, school districts, amenities, market prices and other local factors you’d want to consider before shelling out money for your new home.
Your agent can also give you some advice on certain aspects of local property that may help it increase in value.
4. If Possible Get Preapproval for a Mortgage
When a lender preapproves you for a mortgage, it tells you exactly how much it’s willing to loan you to pay for a home. That decision hangs on a thorough review and verification of your financial, credit and employment history. Your preapproval will come in the form of a letter. It will also contain an initial interest rate as well as terms of the loan.
Mortgage preapproval significantly boosts your chances in the housing market. For starters, most real estate agents expect you to be preapproved for a mortgage before you knock on their doors. Think of it as a seal of approval that tells agents you’re someone they can trust and that you’re serious about buying a home.
Here’s a list of the types of documents usually needed to apply for preapproval:
- Proof of identity – Driver’s license or government-issued ID, passport, Social Security card
- Proof of employment history – Last 30 days of pay stubs
- Tax documentation – Recent federal and state tax returns with recent W-2s, or your most recent 1099 forms if you’re self-employed
- Bank statements – Last three months is usually sufficient
- Asset information – Brokerage accounts and taxable accounts
- Retirement account statements – Documents to verify your tax-advantaged accounts
- Records of debt obligations – Rent, utilities, student loans, living expenses
- Documentation of other income (ie., real estate or irregular) – Rental income, alimony, gifts and bonuses
5. Choose Your Down Payment and Loan Terms Wisely
For the more common fixed-rate mortgage, you can make payments on over the course of 30 or 15 years. It all depends on what you can afford to pay each month, though 15-year mortgages come with lower interest rates than their 30-year counterparts.
If you’re purchasing your second home before you retire, a strong case can be made for the 30-year payment plan so there is less of a dent in your budget every month. However, you’ll pay more in interest with a 30-year mortgage than a 15-year mortgage. Keep in mind that qualifying for a second mortgage may require you to refinance your first mortgage to reduce the monthly payments on your first home.
It’s also possible to take out a home equity loan and put it toward a down payment on a mortgage for your second home, which will decrease the mortgage amount on your second home. But giving up home equity has costs, since you won’t be able to use that money to cover yourself in a financial emergency.
An increasing number of second-time homebuyers are buying homes using a lump sum of cash. If you go the mortgage route, though, the required down payment may be higher than what you put down the first time. In some cases, second mortgage down payments can be as low as the normal 20%, but others (particularly jumbo loans) can call for down payments of 30% or higher.
It’s a good idea to choose your new property wisely. If you love your second home, all of the mortgage payments will be worth it in the end as long as you can make it work financially. A second home can be the ultimate reward for all of your hard work.
6. Consider the Tax Implications of Buying a Second Home
If you’re investing in a rental property, there are some tax advantages to enjoy. You can generally deduct interest, insurance and taxes against the income you generate from that property. In addition, you can often deduct any losses against other income.
However, 2021 tax laws cap mortgage interest deductions at $750,000. So if you have a mortgage that’s valued at that amount, you generally won’t be able to deduct interest on your second one.
You can also deduct depreciation from taxes. This essentially translates to an allowance for any wear-and-tear damage to residential rental properties for 27.5 years as of 2021 (39 years for nonresidential). In any case, it’s always a good idea to work with a financial advisor and/or a certified public accountant (CPA) to explore the tax ramifications of purchasing a second home.
Buying a second home can be major financial decision. Before even looking at homes, you should make sure you can afford one. So take a look at mortgage rates and your own finances to make sure you can stomach it. It’s also important to understand the tax implications behind renting out an older property, as opposed to having two homes with you and your family as primary residents listed for both. With sound financial planning, you can take out a new mortgage and have your dream vacation home to retreat to after all your hard work.
Tips for Buying a Second Home
- Buying a second home is a major financial decision. Consider working with a financial advisor to make sure that such a purchase will fit into your overall financial plan. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Make sure you’re purchasing a house you can realistically afford in the long run. By shopping for a home within your budget, you’ll ensure that the inclusion of a second home mortgage won’t affect your other financial responsibilities.
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