July 26, 2023
Remember how excited you were when you closed on your current home? You were probably on cloud nine and excited for all the memories you’d make in your new home. But buying a second home can feel even better than those jittery moments at the closing table when you were a first-time homebuyer because now you’ve proven to yourself that you can handle the responsibilities of homeownership and probably have more financial security if you’re ready to invest in more real estate. You already know how long the home buying process is, tax benefits of owning a home, and more. Maybe it’s been your lifelong dream to own a vacation home (preferably somewhere on the beachfront), or maybe you want to use a second home as an investment property.
Regardless of your motivation to buy a second home, you’ll have to start from the drawing board and figure out how to buy a second home and the best financing option for your situation. Even before you consider a second home mortgage, a home equity loan, or tapping into your savings, though, you must determine whether you can indeed afford a second home without jeopardizing your financial future.
As much as it’s exciting to own a second property, it shouldn’t come at the expense of your financial security. Because you already have a primary residence, your second home is more of an extra than an essential purchase. Therefore, your decision to purchase a second home should not derail your main financial goals, such as saving for retirement or depleting your emergency fund.
To make an informed decision on whether you’re ready to buy a second home, weigh the following financial considerations:
Typically, lenders have more stringent requirements for second home financing. Most lenders charge higher interest rates and require larger minimum down payments (usually between 10% and 20%, but sometimes even more). Lenders demand high down payments for second homes to minimize their risk. They feel it would be easier for you to default on your second home mortgage than your first home mortgage in case of a financial downturn.
On the whole, a 10% down payment is the minimum most lenders will ask for. And that’s if you have a good credit score, preferably 700 or higher. If you have a lower credit score, expect to put 20% or more down, coupled with higher interest rates. Therefore, if you can afford more than 20% of the purchase price of a second home, you’re in a good position to make a purchase.
DTI ratio is the percentage of the pre-tax income you use to service your debts. Mortgage lenders calculate your DTI ratio by dividing your total monthly debt payments by your gross monthly income. Your total monthly debts include all your ongoing debt payments such as auto loans, student debt, credit card debt, and your primary mortgage (if you have one). If your DTI ratio is more than 43%, most lenders will be reluctant to approve your mortgage application. Conversely, a lower DTI ratio will boost your chances of loan approval.
Say you meet all the conditions for affording a second home — you can easily afford a 20% down payment, your credit score is excellent, and your DTI ratio is well under 43%. You’d probably be confident that a lender will approve your second mortgage loan, and you’d be right. But just because you qualify doesn’t mean because you can necessarily afford a second home. Before you start making offers, remember your second home will add to your monthly expenses by a substantial margin.
Will the additional costs be a smart move financially? It depends. You’ll have maintenance costs, monthly mortgage payments, homeowner’s association fees, and property taxes on your plate. Think about how these additional costs will affect your cash flow. If there’s a possibility that these extra costs can sink you into debt, then you may want to skip buying the second property until you have a higher income or can pay down other debts and expenses.
Even if you’re planning to have your second home as a rental property and channel the rental income towards your mortgage payments and extra expenses, you should still make sure you can afford the payments independently for at least 6 months because the home may not rent as soon as you planned.
Once you’ve determined you can afford a second home without crippling your finances, it’s time to weigh your financing options. Let’s explore all the second home financing options at your disposal.
Like most big purchases, the most convenient way to own a second home is through an all-cash purchase. With a cash purchase, you won’t have to deal with a monthly mortgage payment, and you may get a better deal in a competitive market because sellers prefer less-risky cash offers with no contingencies. On top of the purchase price, you’ll pay closing costs (about 2% to 5% of the purchase price), title fees, home appraisal, and inspection fees, and the applicable property taxes.
If you already have substantial equity in your primary residence, you can borrow from it and get a home equity loan to make a down payment on a second home. You may even be able to use a home equity loan to make a full purchase if the loan amount is sufficient. Although not all mortgage lenders offer this option, those that do allow you to borrow up to 85% of your home equity.
The downside to this option is that you risk losing your primary home if you default since your house is used as security. More so, homeowners who are 55+ and own their primary home outright may use an equity release mortgage to afford a down payment or the purchase price of a second home. Through equity release, homeowners can leverage their home’s equity to get a lump sum of money or multiple small payments, payable when the homeowner dies or moves into long-term care.
A conventional, fixed-rate loan is the most common second home financing option for homebuyers. As long as you have an excellent credit score, a strong debt-to-income ratio, and substantial cash reserves, most lenders will approve your second home mortgage. But you’ll have to put down a bigger down payment and pay a higher interest rate than your first mortgage — typically less than 0.5% higher if it’s a vacation home, and 0.5–0.75% higher if it’s an investment property.
Before we discuss how to close on a second home and find a real estate agent to guide you through the buying process, let’s answer two FAQs many homebuyers have.
YES, you can have more than one vacation property. However, the third, fourth, or fifth home must satisfy the description of a second home as set by the Internal Revenue Service (IRS) for tax purposes. The IRS considers a property to be a second home if:
With such liberal conditions, it’s easy to convince the IRS that your fourth or fifth house is a second home and not an investment property. The catch is convincing mortgage lenders the same. Lenders will dig for more details and may require a letter of explanation and tangible proof that your primary residence and your second homes are in isolated locations.
YES, it’s somewhat more difficult than buying a primary home, thanks to the stricter lending requirements most lenders impose on second home mortgages. It’s even harder to buy an investment property because of the inherent risk to lenders if you’re unable to rent it out or re-sell it.
At this point, you know you can afford a second home, and you have established your ideal second home financing option. From here, you need to find a buyer’s agent who’s well acquainted with the area you desire to buy your second home.
A local real estate agent who knows the area where you want to buy a second home is best positioned to help you get the best deals in that local market. Your agent can also recommend a suitable lender who works with second-home buyers so you can get pre-approved for a mortgage fast. Read our post detailing mortgage pre-approval vs pre-qualification for more information. So, how do you find a local real estate agent you can trust? That’s where Newzip comes in.
Using Newzip’s free online agent finder tool, you can get matched with a qualified local real estate agent instantly. We rely on our exclusive data-driven matching technology to scan a national database of thousands of real estate agents and instantly recommend a top-performing agent who knows your local neighborhood inside-out.
At Newzip, we believe in making real estate transactions as seamless as they can get. You’ve done well to afford a second home, and we believe you shouldn’t struggle to find a buyer’s agent who’ll have your back throughout the entire transaction. That’s not it, though. We go even further and reward you with a cashback rebate when you work with the agent we’ve matched you with to buy a home.
