Home ownership is one of the biggest investments you can make in life. If and when you consider buying a second home for pleasure or potential rental income, the decision warrants thoughtful and careful consideration, especially in terms of your finances and long-term financial goals. You need to be prepared for the long-term responsibilities that come with owning a second home – from unpredictable and potentially costly maintenance repairs to taxes and the inevitable nuances of having renters – you need to ensure you are both financially and mentally prepared for the responsibility you are assuming. Here are five things to reflect on before you take the next steps towards ownership of a second property.
Think big picture: What is the full financial impact of owning a second home? When you become a homeowner, all of the financial responsibility for that property falls on your shoulders, and when you have a second home, that responsibility doubles. When maintenance problems arise, these are your sole responsibility and these often-unpredictable costs can demand a chunk of your savings. Make sure you have a sufficient emergency fund for both of your primary and secondary homes. You do not want to tap into your retirement savings to cover a poor real-estate decision. With two homes comes double the usual bills: property taxes, home insurance, homeowner’s association (HOA) fees, utility bills, etc. Create a detailed budget that comprises all of your costs and make sure your monthly cash flow – including what you defer to your retirement accounts – can comfortably handle the financial demand of more real estate.
An important question to honestly ask yourself: Can you afford a second home? Do not overlook the potential costs you may need to cut down on to fulfill your second-home dream, and if you have a partner with whom you share finances, make sure he or she is on the same page with you financially so you both fully understand what owning a second property will mean for your financial lives and overall lifestyle. Just as with buying a first home, there are high transaction costs with a second home. Additionally, real estate is not a liquid investment; if and when you decide to sell either of your properties in the future, keep in mind that those will take time to sell.
As the old real estate adage goes: Location, location, location! Where you buy is a key factor when it comes to real estate. A house is a permanent structure: Where it’s built is where it is gong to stay. Consider the valuation of the area you are buying in. Do you feel confident in the stability and development of the area? Is your home in a coastal area that could see hurricane damage over the years? Do you foresee your equity growing in the future? If you decide to sell the property at some point, you want to make sure you do not have to do so at a loss, and location plays a big role in that.
Furthermore, if you are buying a second home as a vacation spot, make sure it’s in a place that you will want to visit for years to come, and consider the rental potential if that form of passive income is on your radar. If you are buying a property exclusively to try your hands at being a landlord, make sure you are buying in an area that will attract renters now and in the future. Additionally, be aware of the convenience of your property to grocery stores, restaurants, gyms, golf courses, etc. A second home with accessibility to everyday necessities and activities that bring you (and potential renters) happiness will help your property retain appeal and desired comfort.
3. Second Mortgage
Although this falls into the “expenses” category, this potential second mortgage warrants its own section. If you are still paying off the mortgage on your primary residence and decide to assume the financial responsibility of a second mortgage to purchase your dream vacation home or rental property, there are a few things to keep in mind. As a bank does for any loan, it will consider whether or not your income is sufficient to cover the monthly costs you plan to take on. Be prepared to have you credit reports examined, along with your employment and income history, additional assets, and liabilities, when you apply for another mortgage.
To see if you qualify, you will need to know your debt-to-income ratio, which is how much you owe in relation to how much you earn. A good rule of thumb is to not have your debt payments exceed 36% of your monthly income; and lenders will look at this number carefully. You will also want to make sure your credit score is up to par because you will need a higher-than-average credit score to qualify for a second mortgage. Additionally, take note that you will need to have a significant down payment saved for your second home, as lenders typically require down payments of somewhere between 25-40% for second-home loans. Lastly, interest rates on second-home loans tend to be slightly higher than the rates for primary residences. Although a 1% difference does not seem like much, that amount can significantly add up and compound over the course of a 30-year mortgage.
4. Second Home vs. Investment Property
There are important differences between purchasing a property as a second home versus purchasing it as an investment property to be rented. These terms matter because there are different tax and lending implications for second homes and investment properties, and you need to be aware of which financial costs and obligations you are assuming.
According to the Internal Revenue Service (IRS), a second home is either classified as a personal residence or a rental (investment) property. The property is considered a personal residence if you rent it out 14 days or less a year; if you rent the property out more than 14 days a year, it is classified as a rental property. Note that regardless of what type of property it is, you will always have to report your rental income. If your second property classifies as a rental property, you will not be able to claim the mortgage interest tax deduction, but you will be able to claim losses on the property if the amount you spend on the property in a given year exceeds the income you earn from the property. Also, keep in mind that currently, the home mortgage interest deduction (HMID) only allows you to deduct mortgage interest paid on up to $750,000 worth of principal total for the properties you own.
Talk to a tax professional to ensure you are fully aware of the liabilities and deductions you will be subject to.
Most people consider purchasing a second home for the freedom to escape to a place they love at any time without the stress of having to make reservations and find a place that fits their desired timeframe. If you enjoy traveling and foresee yourself continuing to travel to other destinations after you have purchased your second home, keep in mind that the costs you are assuming with the second property may hinder your financially liberty to venture to other destinations. Additionally, make sure that the travel time between your primary residence and your second home does not become burdensome. If you plan to escape to your second home often, you want to ensure the drive or flight is as easy and stress-free as possible. Lastly, reflect on the lifestyle of the area you are purchasing in. Does it represent a place you can see yourself enjoying for years to come? Some people visualize themselves on the beach forever, while others may yearn for more peace and quiet at a lakeside mountain escape. Make sure you discuss your vision with your partner as well.
Owning a second home can be a risky investment, which is why thoughtful consideration is of the utmost importance before making such a financial commitment. Many people mistakenly view real estate as a safe purchase sans deliberation of the many financial and lifestyle pieces that need to be examined before putting the second-home-purchase puzzle together. Although on paper you may be easily able to afford the upfront costs of owning a second home, do not lose sight of the long-term financial responsibilities and how such obligations may affect your big-picture and retirement goals.