Are Second Homes and Investment Properties the Same?
Many people have taken advantage of the last year to become homeowners. Mortgage rates have fallen to and remained at historically low levels, which has encouraged people to buy homes. Last year, we saw a lot of people become first time homebuyers. However, many existing homeowners also looked to take advantage of these low mortgage rates and buy additional homes. A lot of these additional houses are actually second homes. It seems to make sense that people are buying additional homes as investment properties. However, many of these are actual second homes and not investment properties. Second homes and investment properties are not the same. They serve different functions and applying for a mortgage on a second home is different than an investment property. What are the differences between them in terms of their function and the mortgage process to buy them?
What is a Second Home?
Second homes and investment properties are different. Second homes are also known as vacation homes. People who buy second homes or vacation properties intend to own them and use them for themselves. In 2020, we saw a large increase in vacation property purchases. Many attribute the increase in second home sales to the way our lives have changed as a result of the pandemic. Many more people are able to work from home and school their kids from home, which means they are not tied to their main residence. As long as they have access to the internet, they are able to stay anywhere they want for extended periods of time. This has made vacation properties or second homes much more reasonable for many Americans. Second homes are often located in vacation hotspots or places where the owners want to spend a significant amount of time.
What is an Investment Property?
Investment properties are also an additional residence, but they are intended to be rented out to others. These properties are purely an investment. Owners have no intention in living in them themselves. They are designed to help build additional assets of the owner while making a profit by charging rent that is more than the mortgage payment. To be clear, those who own second homes or vacation properties can also rent out their homes. However, it can only be rented out for a small portion of time, such as peak vacation season. This allows vacation property owners to charge large rates on the brief rental period, which helps offset the mortgage payments. Since owners have no intention of living in their investment property, the location doesn’t matter much. They don’t have to be in their own state or even a place they like. Location is entirely dependent on market factors.
Applying for Mortgages for Second Homes and Investment Properties
Some people who buy second homes or investment properties have the financial means to simply pay cash. For many reasons, this is ideal. However, most people are not in such a financial position, which means they need to get a mortgage. Applying for a loan for additional properties other than your main residence is much different than the process you’re familiar with.
The first difference between getting a mortgage for second homes and investment properties is the interest rates. You are going to have a higher mortgage rate for your additional property than your main residence. The simple reason for this is that they are riskier loans for lenders. In the event you come into hard financial times, it is far more likely you will stop paying your mortgage on your second home than your main residence. As you can expect, this means that there is a higher risk of foreclosures on second homes and investment properties. Lenders charge you a higher mortgage rate to offset this risk.
The second big difference is that lenders will put you through greater financial scrutiny. Specifically, they will expect that you have a lot more cash available than if you were applying for a traditional home loan. Lenders want to make sure that you are able to sustain financial disruptions and still be able to make your payments.
The third big difference in the mortgage process is that lenders will want a larger down payment. Typically, you can expect to put down 15-20% on a loan for a vacation or investment property. Traditional mortgages require a much smaller down payment. This is especially true for first time homebuyers or those that qualify for special loan programs like USDA Loans or VA Loans. Programs, such as FHA Loans for first time homebuyers only require a down payment of either 3.5% or 10%. Again, this is all because these are riskier loans, so lenders want to make sure they are covered if things go wrong.
All of the above requirements apply to both second homes and investment properties. However, there are some differences between the two of them. One difference is that investment properties must get an appraisal in order to prove their potential rental income. Lenders want to make sure that the potential rent will cover the mortgage payment. Another big difference is location requirements. Many lenders will require that second homes must be within 50-100 miles of their main residence. Rental properties do not typically have these types of distance restraints.
Another big difference is the way that the IRS treats second homes versus rental properties. For second homes, you are able to deduct a portion of your mortgage payments very similar to the mortgage on your main residence, depending on if you rent it out for periods of time. For investment properties, you can deduct portions of your mortgage plus expenses that are associated with renting out your property. It is important to remember that the tax implications for them are very different, so it is important to speak to a tax professional before filing.
Final Thoughts
Today’s low mortgage rates mean that there is no better time to buy an additional house if you are in the position to do so. However, it is very important that you know going into the mortgage application whether you intend for it to be a vacation home or a rental property. You must disclose this information to your lender in your application. If you do not honestly disclose your intentions then you will be committing mortgage fraud. That makes it especially important to work with a trusted, independent mortgage broker who is experienced with these transactions. You want to make sure that you are following the exact rules and regulations to avoid getting yourself into trouble. If you are interested in buying a second home or a rental property, contact us! We will walk you through the entire process and make sure we set you up for success.
