You would think that buying a second home would be the same as purchasing the first.
But, unfortunately, that’s not usually how it pans out. The process is often significantly more complicated and involves many tax implications than don’t apply to a regular property transaction.
There are additional considerations if you’re planning on buying a second home to let out as a property vacation. In this article, we’re going to investigate how to finance a second home efficiently. You should have a much better understanding of where you stand and the options available to you by the end.
Related: How to Get Out of a Mortgage
What Are the Benefits of Having a Second Home?
The benefits of having a second home are extraordinary. On the financial side, you can use them to create passive income and increase your overall wealth. Renting them out full-time or using them as a holiday rental lets you boost the amount of cash entering your bank account every month.
There are also non-financial benefits. For many people, second homes become a kind of secret getaway – a place where they can go to leave their troubles behind and escape for a couple of weeks of the year. It is often in an idyllic location, such as the coast or the mountains, allowing them to live the lifestyle they cherish. Are you thinking about buying a second home? Let Mares Mortgage help.
What Are the Best Ways to Buy a Second Home?
There are several ways to finance a second home you may wish to consider:
Reverse mortgages are a resource people aged 62 or older can use to finance a second property. These government-sponsored loans let you borrow money against your current property without paying mortgage payments until you either leave or sell your primary residence.
Reverse mortgages significantly reduce the amount of money you receive when you sell your home, but they allow you to hold onto your existing savings. You can think of it as using the equity built up in your current home to finance a second one. Thus, you can buy a holiday home, even if you don’t have an income.
Of course, reverse mortgages can come with a cost – the reduction in the amount you get for your property. But because it is a government-backed program, rates are favorable, and you often wind up more money than expected.
Home Equity Loans
Home equity loans let you take finance in proportion to the equity you’ve already built up in your home.
Home equity refers to the portion of your property that you own outright compared to your outstanding mortgage. Equity, therefore, is an asset – something you can use to gain access to additional credit.
If a mortgage lender sees that you have significant equity in your home, they feel more confident that you will pay it off. You’ve already proven an ability to pay off a mortgage. And now you have collateral in your property that the lender can access, should you fail to meet your repayment obligations.
Typically, home equity loans offer a fixed rate of interest. Thus, the fees you pay for taking out the credit don’t change over time. Lenders will typically calculate the loan size you can afford and offer you a deal based on that.
Home Equity Finance
Home equity finance is one of the cheapest ways to borrow money to pay for a second property. Lenders can see that you already have net-positive wealth in your property (because you’ve paid down your first mortgage). For that reason, they feel more secure about lending to you.
Furthermore, this confidence means that lenders are willing to offer lower interest rates. If you have a good credit history, you can often get finance for just a few percentage points above the base rate.
Additionally, home equity creditors don’t usually specify how you must use the cash. We’re assuming that you will use it to buy a second property in this discussion. But there’s nothing in the rules that says that you have to.
Home equity finance comes in two forms: home equity loans and home equity lines of credit, which we discuss next.
Home Equity Line of Credit (HELOC)
A home equity line of credit is different from a loan. When you take out a loan, you have to pay it back in set installments, according to the lender’s agreement. If you miss payments, it can hurt your credit report. And if you can’t afford to repay the debt, they may have the right to foreclose.
A home equity line of credit, however, works differently. Here, you get a facility that feels a lot like a credit card. It is the same, in the sense that you can use and pay back money up to your credit limit on a schedule that suits you. But it is different since HELOC is secured against your property. Thus, unlike credit cards, which are a form of unsecured lending, home equity line of credit provides the lender with collateral. And, ultimately, that means you pay a lower rate of interest on the money you borrow.
Tax Concerns With Using Home Equity
In 2018, the tax code updates meant that interest on home equity lines of credit was no longer tax-deductible unless you use the proceeds to improve the home you secure. The change in policy was designed to incentivize people to use their home equity release to refurbish their second property, instead of spending it on other things.
Therefore, the change in the code means that if you take out a home equity loan, you can no longer deduct the interest to reduce your net taxable income, as you could in the past, even if you bought a vacation home using the proceeds. Strangely, though, if you use home equity financing to fund renovations, you can deduct this from your taxable income.
How you choose to use HELOC depends exclusively on your finances. If you already have a property and just need to release credit to carry out repairs, this remains a tax-efficient solution. If you plan on using it to purchase outright, you must pay the interest out of your taxable income, just like regular credit products, like credit cards.
In some cases, you may be able to assume the existing mortgage of the person selling the second home, instead of having to take out a new one. Investors in second homes often look for opportunities to get a loan assumption on vacation homes with pre-existing favorable mortgage arrangements, such as VA or FHA. These products typically offer much lower interest rates than non-government-backed alternatives.
Finding a second home with one of these mortgages, however, can be a challenge. Such properties are rare and depend very much on the circumstances of the seller. Furthermore, not every lender is willing to accept a loan assumption on the properties you buy.
Cash-out refinance is where you replace an existing mortgage with another one with more favorable terms. People often use this facility when they want to take advantage of lower interest rates. It is, however, a tool you can use to take cash out of your home.
You simply take out a mortgage for more than the money outstanding, receiving the cash difference to use how you like (such as purchasing a second home). Essentially, therefore, it is like resetting your mortgage, once again increasing your liability.
A 401(k) loan is a tool you can use to take out money and then repay it in regular installments. These loans are typically interest-free. When you pay interest on them, it goes right back into your savings account, ready for you to access in the future. The downside is that you will lose out on the return that your borrowed funds could have generated, had you left them in your account. If you default on any outstanding loans, the IRS may decide that they are not tax-deductible, increasing your income tax bill.
Additional Home Buying Tips
Find a Trustworthy Agent
Finding a second home is a challenge, particularly if you plan on buying in an area you don’t know much about. Choosing a savvy agent, therefore, is vital. They will be able to give you all the information you need to make a sound decision.
Plan for Unexpected Costs
Invariably, you will face unexpected additional costs when buying a second home or vacation property. Things like having to renovate the property or paying a company to manage it when you’re not there all eat into your returns. You may also have to pay additional insurance costs if you rent it out.
Make Sure You Can Afford a Second Home
Unfortunately, not everyone can afford to purchase a second home upfront. The amount that you can borrow will depend on how much of your after-tax income already goes towards paying the mortgage on your existing property. If you’re close to your limit, you may not be able to borrow more money.
Consider and Understand the Tax Implications
Taxes on second homes differ from those on primary residences. Again, this can eat into your returns and cause you financial headaches if you don’t fully understand it. You can’t, for instance, deduce second-mortgage interest from your taxable income.
When it comes to financing your second home, therefore, you have plenty of options. So long as you have sufficient wealth already, you can typically generate substantial additional income from a second property and enjoy it whenever you like.
Are you ready to explore your options? Get in touch with us today.