Maybe you were just on an inspiring trip that has you in love with a new town, or your family visits the same place every year and you are considering if it’s better to own than rent.
Travel to a great town or city can fill you with emotion and the next thing you realize you are looking at the local real estate listings.
Admittedly this happens to me, the most recent was a visit to Colorado. Picturing a house up on Sunshine Canyon Drive outside of Boulder – the Colorado weather, scenery, and close proximity to a college town, a major city, and national park. Or, maybe further up into Frisco or Breckenridge to really embrace mountain life.
Then, the real questions sink in – could we afford it? Does it even make any sense? Will this move us toward or away from our goals? What if we rent it to help off-set the cost of purchasing and ownership?
Can you afford it?
Real estate is expensive and buying a second home is a big investment. Let’s look at what it takes to afford and buy a property.
First, a word on classification - Second Home vs. Investment Property.
This stuff matters to the IRS and mortgage lenders, and differences apply based on how a property is classified for lending and tax purposes. In this article we are talking about buying a second home or vacation property, with plans for personal use, and potentially renting it out part of the time. We are not discussing purchasing an investment property to be rented out full-time.
What classifies as second home? Per the IRS, to be a second home you must live in it more than 14 days per year or 10% of the number of days rented, whichever is greater. The good news is that lenders have recently come around on this concept as well and are more lenient when considering properties as a second home, even if rented part of the year.
While a fair amount of second home purchases are made with cash, most will need to look at financing options. Lenders may require a down payment of 20% on a second home, and interest rates may also be higher than on a primary residence loan, though lower than for an investment property.
Your debt-to-income ratio is also important and must remain within lending guidelines. This can vary by lender, but maximum DTI is generally in the 40%-50% range. Although, spending 40% of your gross income on housing is likely a roadblock to building long-term wealth.
Keep in mind with a second home purchase any potential rental income isn’t considered by the lender when calculating your total debt-to-income ratio. However, if renting is part of your plan, that income can make a big difference and help reduce your debt/payment burden. Lastly, don’t consider tapping the equity on your primary residence. If this is part of the equation, you can’t afford a second home.
Remember, qualifying for financing on a property doesn’t mean you can afford it. What else do you need to think about?
Major costs to ownership:
- Mortgage principal and interest payments
- Property taxes
- Homeowners insurance
- Utility bills
- Maintenance costs and property management
- Major repairs
- Furniture and decoration
Set a budget and review the numbers to determine if you are ok with other goals and can prioritize this spending amount. Are you able to save at least 20% of your income toward other long-term wealth? Is your debt-to-income ratio above 30%?
- Are you clear on your goals for this investment? Are you making an emotional decision?
- Will your income be enough to maintain any additional or unexpected costs for the next 5, 10, 15, 20 years?
- Will you use it enough – Is your family on the same page? What is the travel time like to get there? Is it easy or does it require flights or navigating high traffic areas?
- Can you handle the idea of renting to strangers? How often will you rent, and will this affect your intended use of your property?
How will this impact your taxes?
A second home varies from an investment property for tax purposes. If you satisfy the IRS’ 14-day/10% rule, you will be able to deduct mortgage interest and property taxes. The Tax Cuts and Jobs Act of 2017 currently limits deductions for interest on qualified personal residence mortgages up to $750,000 and state and local taxes to $10,000 per year. Accounting for rental income and expenses can be a little tricky and should be discussed with a qualified tax professional.
Is this a good investment?
Maybe. Maybe not. There is potential for price appreciation and the ability to generate rental income to offset costs, but there may be more efficient and potentially higher returning ways to invest money. If you are looking at for the best return potential, an investment property or the stock market may be better options for you.
We know rental income can be unreliable, property management is a headache no matter how ideal the situation, and most vacation homes are located in seasonal areas adding to the complexity. Not to mention renting may limit your ability to enjoy the property as intended. The real benefit lies in using the property and spending time somewhere that brings joy, and hopefully building an asset over time.
We help our clients to closely work through the numbers and research the market being considered. Once we have an idea if the numbers work, it’s important ask – is this decision in line with what’s important to me? Is it moving me closer or further away from my values and goals? Does it bring joy and purpose? Is it the best use of our resources?
Scenarios that fit
There are two scenarios where this works best.
First, you absolutely love the location and property, want to spend a significant amount of time there, and your family is on the same page. It should also be relatively easy to get to, affordable, and you are committed to making the most of your second home.
Second, you plan to retire there. If you are planning on relocating in retirement this can be a great way to gradually transition. Locking in today’s prices, using it frequently and renting it out occasionally to help offset the cost. Then eventually making this your primary residence as you phase into retirement.
Bottom line, buying a second home shouldn’t be a stretch. Do your research, work with an experienced real estate agent and don’t get emotional.
If you have questions, thoughts, or an experience you’d like to share – please send a note, I’d love to hear from you.
The opinions voiced in this material are for general information only. This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal, or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material.