Picture this. You’ve worked hard every day for years. You’ve put as much money as you can away for retirement and you’re able to support your family and live comfortably. After years of responsible behaviour and sound financial planning, you’ve decided buying a second home is right for you. Maybe it’s nestled next to a sandy beach or living among a quaint small town charm.
The tangible next step to this realization could be looking at a local real estate guide and perhaps even calling a real estate agent to look at some available properties for sale. Before you know it, the idea of having a second home could take root. Before you make any major decisions make sure you break down the pros and cons of such an investment.
Decide why you want to Buy a Second Home
Living in a desirable resort or a home away from home could be a dream come true, however it is important not to get distracted by the greener grass on the other side. Ask yourself the hard questions like, “Why do I really want a house here?” and “What would I do with a second home if I had one?
As in any real estate transaction, location is the first, second and third most important consideration. Be sure to research local resale values, economic trends, tax rates, schools, health care and amenities. Ultimately, the ideal area for your second home will depend your core reasons for owning a second home. Here are some possible uses for a second home:
- Spend more time in a favourite vacation spot
- Provide an investment that could produce income and eventually appreciate in value
- Fix and flip
- Give you a place to move to when you retire
- Rent to others short-term while also allowing you to visit frequently
- Give you a place to move to permanently, so you can rent or sell your current main residence
If you’re considering moving into the house permanently, or even keep it as a vacation home, you might consider first renting a home in the same area for a short time. This will allow you to test life at the location before committing to a massive purchase. If finances are tight, don’t be afraid to get creative. You may be able to share ownership of a second home with another borrower and still make your dream of owning a second home come true.
Resist the urge to impulse buy.
Don’t come back from vacation with the keys to a new house without having thoroughly researched your purchase first. If you buy on a whim, you may end up with a second home you can’t afford or that doesn’t fit your needs.
Determine if you can afford Buying a Second Home?
First things first, you’re going to need to run the numbers to ensure that 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 only a small portion left to pay off.
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 will 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. As you know, the interest on your mortgage is just a piece of the puzzle. Keep in mind that down payments on second mortgages tend to run from 10% to more than 20%.
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 in mind, 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 provides you with a peace of mind.
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 already paid off your first mortgage. A good real local estate agent can help you run the numbers to give you an estimate of what is to come.
It’s not impossible to get a loan with a lower credit score. 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. 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.
A good real estate agent can offer crucial insight into factors like neighbourhood 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.
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.
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. Buying a second home can be the ultimate reward for all of your hard work.
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 a major financial decision. Before even looking at homes for sale, you should make sure you can afford one. Take a look at mortgage rates and your own finances to make sure this is even an option. 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.
Sound financial planning will enable you to take out a new mortgage and have your dream vacation home to retreat you after all your hard work.