Since the risks and advantages of loan products vary for each borrower, it’s best to talk to a licensed loan professional to determine what’s best for you.
After you settle into home ownership, it’s natural to start thinking about buying a second home. A house by the lake. A cabin in the mountains. A condo in a resort destination. And why not? When you get it right, a second home offers numerous quality-of-life and financial benefits. Of course, it will also come with a raft of new responsibilities, such as maintenance and tax implications. While these are also important factors to consider, here are the key things you need to know about financing your second home.
Use it or lease it
Renting out a second home for a portion of the year or longer is a great way to defray some of your costs, and maybe even turn a profit. But renting it out too frequently could affect your loan terms. If you’re financing your second home, you’re most likely going to get a better interest rate when you plan to use it primarily for yourself and your family. Otherwise, it will be considered an investment property. And investment-property loans typically come with higher interest rates and require larger down payments. That said, there are also some advantages to investment properties. For example, the potential rental income could help you qualify for the loan in the first place.
The debt-to-income (DTI) requirements for second homes are similar to those for primary residences. Your lender wants to make sure that you can afford to take on this new debt. Most lenders will avoid issuing a loan that’s going to bring your total monthly debt payments, including your existing mortgage and things such as car payments and credit cards, above 45% of your income. However, they might consider higher DTI ratios for clients with compensating factors, such as exceptional credit.
Cash or equity
If you have the cash for a down payment, your best bet is typically going to be a conventional or jumbo loan for the second home, assuming you have the income. But you can also tap into the equity that’s built up in your primary home through a home equity loan or cash-out refinance. These are among the most common ways to raise cash to for a down payment or an outright purchase of a second home. With a home equity loan, you’ll receive a lump sum that you’ll repay with regular monthly payments, while the terms of your existing mortgage remain the same. A cash-out refinance, on the other hand, folds your existing mortgage into a larger new loan with a single, albeit larger, monthly payment.
In addition to your DTI, lenders will also review your home’s loan-to-value (LTV), which is the ratio between the sum of your mortgage balances and the home’s value. If your home appraises at $500,000, and your existing mortgage balance is $200,000, your current LTV would be 40%. A $200,000 home equity loan or a $400,000 cash-out refi would bring your LTV up to 80%, which is a common cap for second mortgages and cash-out refis. However, depending on the loan product and your creditworthiness, your lender might allow a higher LTV ratio. Just remember that your new loan will also come with closing costs. These typically range from 2% to 5% of the loan amount, and these can usually be paid with proceeds of the new loan.
You could also finance all or a portion of a second home with a home equity line of credit (HELOC), a revolving line of credit based on your home’s equity. However, since HELOCs normally come with variable interest rates, they are considered risker than the other options.