Imagine this scenario: You work hard every day for years at a job you love. You put as much money as you can away for retirement, you support your family and live comfortably. After years of responsible behavior and sound financial planning, you decide to buy a dream vacation home. Maybe it’s nestled on some white sand or sitting atop a mountain in the Adirondacks. To make this all happen, you approach your bank to take out a mortgage on a second home.
Before you make any major decisions however, make sure you break down the pros and cons of such an investment. Below, we’ll explain some key factors you’d want to consider before buying a second home.
1. Can You Afford A Second Home?
First things first, you’re going to need to run the numbers to make sure you can afford a second mortgage in the first place. Ideally, you’ve paid off your first mortgage. Or you’ve made timely payments and have taken a sizable chunk off your first one.
Moving forward, there are some new numbers to which you should apply a magnifying glass. Of course, you’d be taking on new debt partially in the form of a new mortgage.
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 housing crisis of the Great Recession, 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 second homes.
But as you know, the interest on your mortgage is just a piece of the puzzle. Our mortgage calculator can give you a sense of the bigger picture by accounting for factors like taxes, fees and insurance.
And keep in mind that down payments on second mortgages tend to run from 10% to more than 20%.
You can use our digital tool to figure out how much you can afford for a new home based on your individual finances.
2. Vacation Home or Rental Property?
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’re doing 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 will, however, be able to deduct expenses related to the upkeep of the property during the days tenants occupy it each year.
With that said, are you ready to be a landlord? In addition to complying with local landlord laws, you could face other potential headaches. You may have to respond to a water leak or frozen pipe in the middle of the night. Of course, this all takes money.
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 maintenance costs each year.
Of course, you can hire a good management company to cover this as you kick back. But this will eat into your savings and earnings. So a solid financial plan is a must. A good financial advisor can take a deep dive into the numbers to make sure this venture is overall profitable and easy on your peace of mind.
3. Find the Right Real Estate Agent to Run the Numbers
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 the second mortgage) to climb more than 36% of your monthly income before taxes. This accounts for your debt-to-income ratio. But 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. Choose Your Payment Plan Wisely
You can make payments on your second mortgage in the course of 30 years or 15 years. It all depends on what you can afford to pay every month. A mortgage with a 15-year term will come with higher monthly payments than a 30-year mortgage.
If you are 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 – you won’t be able to use that money in the event of a financial emergency.
5. Consider Making a Lump Sum Payment
An increasing number of second-time homebuyers are handling their transactions in a lump sum of cash. Before applying for a mortgage, a down payment is often required, and in the case of a second mortgage, the required down payment may be higher than what you had to put down the first time. The down payment on second mortgages can be as low as 20% but can clock in around 32%, particularly on jumbo loans.
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, tax laws cap mortgage interest deductions at $750,000. So if you have a mortgage that’s valued as much, you generally won’t be able to deduct interest on the second one.
You can also deduct depreciation from taxes. This essentially translates to an allowance for any wear-and-tear damage for more than 27.5 years as of January 2019.
In any case, it’s always a good idea to seek a qualified financial advisor and 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.
But with sound financial planning, you can take out a new mortgage and have your dream vacation home to retreat you after all your hard work.
Tips for Buying a Second Home
- Make sure you’re saving for a house you can realistically afford. By shopping for a home within your budget, you’ll be better able to pay off your mortgage while staying on top of your other financial responsibilities.
- You may want to talk with a financial advisor when making this or any other big financial decision. So many people reached out to us saying they wanted help with financial planning, that we built a tool to match you with a financial advisor who can meet your needs. First, you answer a series of questions about your situation and your goals. Then, the program narrows down thousands of advisors to just the three advisors who best meet your needs. You can read their profiles to learn more about them, interview them on the phone or in person and choose who to work with in the future. This allows you to find a good fit while we do much of the hard work for you.
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