Buying your first home is a rite of passage that tends to require some handholding from a real estate agent. So by the time you’re in the market to buy a second one, the whole process should be a piece of cake, right? Well, not exactly.
You have the benefit of knowing the basics from your first go-round, but there's some new information that changes the game a bit. Whether you're making a real estate investment or buying a country house for weekend chilling, here are the four things to know about buying a second home.
"If you occupy the property and rent it out for 14 days or fewer throughout the year, your rental income is 100 percent tax-free."
THE STANDARDS TO QUALIFY FOR A SECOND MORTGAGE MAY BE HIGHER
Unless you can pay for your second home with cash, you’re going to need a second mortgage.
Here's the tricky part: Experts generally recommend your total house payments (including your mortgage, maintenance costs, taxes, etc.) shouldn’t exceed 28 percent of your gross monthly income. This number is referred to as your housing expense ratio, and it stays the same whether you have one property or several.
So, for instance, if your monthly pre-tax income is $5,000, you ideally shouldn't pay more than $1,400 a month on your combined mortgage payments (and that still doesn’t cover other housing expenses that come with owning property).
Remember that there may be a big difference between what you qualify for and what you can comfortably afford to spend each month on not one — but two — mortgage payments, says John Muth, CFP®, director of advanced planning at Northwestern Mutual. Your best approach, Muth says, is to talk to several lenders to find out what size loan you can qualify for. After seeing all your options, calculate the mortgage payment you'd be comfortable making each month for your second home.
Depending on how much equity you’ve built up in your first home, you may be able to borrow money against your house — either in the form of a home equity loan or home equity line of credit (HELOC) — to help pay for your second home, Muth adds. This essentially means tapping the money you’ve already invested in your first home to pay for your second, without having to dip into as much savings.
Finally, in addition to your debt-to-income ratio, mortgage lenders will focus on your credit score and the size of your down payment when you apply for a second home loan. Because you’re borrowing a second large sum, which adds risk for the lender, second-home loans typically require more money down — generally at least 10 percent of the loan amount — and a higher credit score than your primary home.
YOU SHOULD CONSIDER YOUR RENTAL STRATEGY EARLY ON
How you plan to use your second home plays a major factor in what to look for, Muth says. According to a recent survey from the National Association of Realtors, 37 percent of investment property buyers bought a second home to generate income through renting, while another 16 percent hoped to make money on potential price appreciation.
If renting out your second home is part of the plan, find out how much you can reasonably expect to charge by looking at similar rental homes in the area. You’ll also want to make sure the property has the features and amenities that will attract renters in that area. If your second home’s mortgage payments and other housing expenses will exceed what you expect to take in, you may want to consider buying a less expensive house.
Also, mortgage lenders often charge more in interest if you intend to rent out the home. Why? Because if you have difficulty keeping a tenant, you could have difficulty making your monthly mortgage payments. Here’s what else to know if you’re considering becoming a landlord.
YOUR HOME CREDITS AND TAX BREAKS MIGHT BE DIFFERENT
Although there are a number of home credits and tax breaks for your first house, not all of them will apply to your second. “Everyone knows mortgage interest is deductible, but that’s only deductible up to a certain amount,” Muth says.
Because of the new Tax Cuts And Jobs Act, which went into effect this year, the cap to the mortgage interest deduction has been lowered from $1 million to $750,000. So, let’s say you have a $500,000 loan on your first home. If you need to obtain a $300,000 loan for your second home, $50,000 of mortgage interest on that debt is non-deductible.
Property tax rules and deductions for second homes can also vary depending on where you live and how often you occupy the home for personal use.
One thing that's consistent nationwide: If you occupy the property and rent it out for 14 days or fewer throughout the year, your rental income is 100 percent tax-free. However, if you rent out the property for more than two weeks, you’ll have to declare your rental income and pay taxes on it. The upshot: 25 percent of your rental-related expense — like utilities or the cost of a property manager — are tax deductible.
A tax professional can tell you which second-home tax breaks you’d qualify for.
CONSIDER EXTRA EXPENSES
Maintenance, repairs, renovations and redecorating should also factor into your financial decision. Property taxes will also add a significant chunk of money to your housing expenses. SmartAsset’s property tax calculator can help you estimate these costs. If you buy a condominium or a home within a homeowners association (HOA), you’ll need to pay association dues. And, depending on the homeowners insurance on your first home, you may have to buy a second policy for your vacation or investment property. In general, second homes tend to be more costly to insure, especially if they’re going to be vacant for periods of time.
Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNERTM and CFP® (with flame design) in the U.S., which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements.