You have your primary residence, but you’re thinking about buying a second home. Congrats! Being in a position to purchase another residence is a major accomplishment, and you should be proud of that.
The first thing you’ll want to do after celebrating your awesomeness is determine the function of this home. There are second homes that are exactly that—additional dwellings regularly used by you and your family. Then there are investment properties that are purchased with the explicit intent of renting them out as a source of income.
There are a few differences between a second home vs. an investment property. They can impact your interest rate, down payment, ability to qualify, and even taxes. So make sure you’re clear on the goals for this property from the start.
Interest Rate
There is a noticeable difference between interest rates on a second home vs. an investment property. Second home loan rates are more like a primary home, while an investment property is much higher. It’s typically 1 – 3% higher, depending on credit and LTV. Why such a difference? It’s because the property is not occupied by the borrower, and most borrowers rely on the income the property generates to fund the home, making these loans much higher risk for mortgage lenders. Keep in mind that for both second and investment homes, your rate is determined by both your credit and down payment—hence, the better the credit and down payment, the better your rate.
Down Payment
A typical down payment on a second home is 20%, though options do exist with as little as 10% down, depending on your credit and other qualifiers. An investment property, on the other hand, tends to require 20% to 25% down. A larger down payment can sometimes lower your interest rate, regardless of whether you’re looking at a second home vs. an investment property.
Reserves
Reserves are savings balances that will be there after you close on your home purchase. These are seen as emergency funds that assure lenders that you will be able to continue making payments, should any unforeseen expenses or income loss come your way.
Some lenders require reserves on second homes and almost always require them on investment homes. These reserve requirements can range from two to more than six months of your total housing payments. You’ll want to keep this in mind when you determine the amount of your down payment so you don’t completely liquidate your savings.
Debt-to-Income Ratio
Since this home is in addition to your primary home, you’ll have to include the mortgage on your primary residence, plus this new mortgage, into your debt-to-income (DTI) qualifying ratio.
Though you may be able to rent out your second home on a short-term basis, you cannot count that anticipated income in your DTI. If your home is an investment property, however, lenders will generally allow you to count up to 75% of your expected rental income toward your DTI. This can require additional paperwork and even a special appraisal to ensure that your rental figures are comparable to the ones in the neighborhood.
Proximity
To qualify for a second home, lenders generally require at least a 50-mile distance between your primary home and this new home. An investment borrower, on the other hand, can live as close or as far from their rental property as they like. Regardless of their proximity to their investment, these landlords should have a property management plan in place to manage the day-to-day operations and maintenance required for an investment property.
Credit Score
As expected, a high credit score is always favorable for any type of additional home purchase. A second home borrower will typically need a score of at least 640. This can hold true for investment buyers as well, though a score above 680 is preferable.
Taxes
Rental income on a second home vs. an investment property is taxed differently. This income must be declared as part of your taxable income if you own an investment home. Second homeowners don’t have to do this as long as their property is rented out for 14 days or fewer per year.
Investment homeowners are also able to deduct depreciation, in addition to property maintenance, advertising, insurance, and utility expenses on their taxes. These deductions can go a long way toward offsetting some of the asset’s rental income.
Second homeowners can deduct mortgage interest (up to $750,000 in mortgage debt), property taxes, and mortgage insurance payments.
The discussion over whether to purchase a second home vs. an investment property is a personal one. It really boils down to your vision for the property. There are pros and cons to both. Don’t go at it alone. Reach out to a mortgage advisor at APM—we are here to assist you in this process.
Contact us today to learn more about these two home purchase options and which one may be best for you based on your individual situation.