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Second Home vs. Investment Property: The Differences

tl;dr

What You Need To Know

  • The key differences between a second home and an investment property are based on occupancy and whether it generates income
  • Second homes and investment properties require a better credit score and a higher down payment than a primary residence
  • You can deduct property taxes, mortgage interest and mortgage insurance from second homes and investment properties

Contents

You’re at a point in your life where you’re financially stable. You own your home and have a steady income. Now, you’re thinking about expanding and buying a second home or an investment property. 

Real estate can be a smart investment that gains value over time. But you may be wondering what the difference is between a second home and an investment property and which option is right for you?

What’s a Second Home?

As the name suggests, a second home is a property you buy in addition to your primary residence and plan on living there for part of the year. 

A second home can be a vacation home or a pied-à-terre (typically a small home or apartment). 

To get a mortgage to buy your second home, lenders may require that:

  • It’s at least 50 miles from your primary residence
  • It’s a 1-unit property (no 2- to 4-unit properties are allowed)
  • It isn’t subject to a timeshare requirement

According to the IRS, a home qualifies as a second home if you live in it for more than 14 days each year or 10% of the time that you use it as a rental.[1]

Benefits of a second home

So why buy a second home? 

  • For convenience: If you have a favorite vacation spot or location where you work regularly, owning your own home can be more affordable and convenient than booking hotel rooms or renting a second home.
  • A future investment: While the housing market may fluctuate, real estate usually appreciates in value. By buying now, you can invest in a property that you enjoy and then sell or convert to an investment property later.
  • To prepare for retirement: You can buy a second home now and make it your primary residence when you retire.
  • To escape the city: Purchasing a second home outside the city can help you build equity more affordably while giving you a place to escape the hustle and bustle of city life.

Challenges of a second home

Of course, buying a second home comes with its challenges.

  • Expense: If you buy a second home, you’ll be responsible for covering both your current mortgage and the mortgage on the second home.
  • Maintenance: If you own a home that you don’t live in year-round, it may require extra time and effort to maintain it, or you’ll have to hire someone to do it for you. 

What’s an Investment Property?

An investment property is a residence you buy exclusively as a rental property. An investment property can be a single-family home or a multifamily property with up to 4 units.

If you own a multiunit building, you do have the option of living in one of the units for part of the year, but it will still count as an investment property.

Benefits of an investment property

A key reason to own an investment property is to earn passive income and build equity at the same time. 

Ideally, you would earn enough from rental income to cover all your expenses, including mortgage payments, property taxes, insurance and maintenance. 

As the value of the property appreciates and you pay off your mortgage, you can borrow against the available equity. In time, you could even borrow enough to buy another investment property.

Challenges of an investment property

If you buy a home to use as an investment property, you’ll need to take responsibility for managing the property, and you’ll need to be responsive to your renters. 

If you aren’t good at fixing things or don’t want to worry about collecting rent, you may want to hire a property management company to do the work for you. While every company is different, property managers will usually collect a fee that’s around 10% of your rental income.

Available Loans for a Second Home or Investment Property

Conventional mortgages

Getting a conventional mortgage loan for a second home also means that the amount you’re borrowing needs to fall within conventional loan limits. 

The 2022 loan limits are $647,200 (low-cost areas) and $970,800 (high-cost areas) for a single-family property,  and $1,244,850 (low-cost areas) and $1,867,275 (high-cost areas) for a 4-unit property.[2]

Government-backed loans

Government-backed mortgages, like Federal Housing Administration (FHA) loans and Department of Veterans Affairs (VA) loans, can’t be used to buy a second home. You can use them to buy a multiunit investment property if one of the units is your primary residence.

Jumbo loans

If the amount you need to borrow to buy your second home or investment property exceeds conventional loan limits, you will need a jumbo loan. Jumbo loans don’t conform to federal guidelines. Lenders can lend you more money, but they may charge more in interest and require a larger down payment.

Investment Property and Second Home Mortgage Requirements

Unless you’ve got enough cash to buy a second home or investment property, you’ll need to talk to a lender (think: a bank, a credit union or an online lender) about getting a mortgage.

The process for getting the mortgage will be similar to the one you probably went through when you bought your first home. 

There are a few factors you’ll need to consider before applying for a mortgage: 

The down payment

Most lenders are going to want a minimum down payment of 10% for a second home and 15% – 25% or more for an investment property.[3]

One way to finance a second home is to borrow against your current home with a cash-out refinance, a home equity loan (aka a second mortgage) or a home equity line of credit (HELOC). 

Keep in mind that most lenders will want you to maintain at least 75% – 80% equity in your home. If you want to borrow enough for a down payment, you’ll need to have enough equity so your combined loan-to-value (CLTV) ratio (the total amount you borrow against your home) doesn’t exceed 75% – 80% of your home’s equity.

Your credit

While you can qualify for a mortgage for a primary residence with an average 620 credit score, most lenders require a minimum credit score of 640 or higher to qualify for a loan on a second home or investment property.

However, with a 640 credit score, you could end up paying a full percentage point more than you would with a credit score of 680 or higher. You’ll be in the best position to qualify if your credit score is 740 or higher.[3]

Your income

If you’re buying a second home, lenders will want to see that you have enough income to cover your current debts and the added debt of a second home. 

Even with an investment property where you’re collecting rent, lenders will want to see that you have enough income or assets to cover your mortgage payments if your rental income ever comes up short.

Your debt

Lenders will take a look at your debts and financial obligations. You should have minimal credit card and student loan debt before considering a second home or investment property. 

Lenders will want to see a debt-to-income (DTI) ratio of 45% or less. Your monthly debt payments, including the mortgage on your primary residence, shouldn’t exceed 45% of your gross monthly income.[3]

Mortgage Interest Rates for Second Homes and Investment Properties

When you get your mortgage on your second home or investment property, you should expect to pay a higher interest rate than the rate you’re paying on your primary residence.

Lenders know that if things go sideways, borrowers are more likely to make payments on their primary residence first. That puts the second home or investment property at greater risk of foreclosure.

Fannie Mae and Freddie Mac, which help set standards for conventional mortgages, also know this and charge lenders a loan–level pricing adjustment (LLPA) fee to buy their loans. This fee can get passed on from the lender to the borrower.  

Based on the LLPA, you could pay at least 0.25% more for a second-home mortgage than you would for an identically priced home that was a first mortgage. For investment properties, you could pay up to 2% more, depending on your down payment and credit score.[4]

Second Home and Investment Property Taxes and Tax Benefits

If you own an investment property that adds to your income, you’ll owe more in taxes. The good news is that you can claim more tax deductions on a second home or investment property than you might be able to with your primary residence.

Rental income

If you own a second home and rent it out for 14 days or less, you don’t have to report the income. Rent out the home for more than 14 days, and the IRS will consider your second home an investment property. You’ll have to report the rental income when you file your tax return. 

Be honest about how you used your property when reporting to the IRS. If you get caught being anything less than honest, you could be charged with occupancy fraud, which could lead to fines and jail time.

Tax deductions

Yes, owning a home can be expensive. But the federal government wants people to become homeowners. That’s why they allow homeowners to write off expenses like mortgage interest and property taxes on their primary residence. 

Writing off these expenses lowers your taxable income, which means you end up owing less in taxes. 

Here’s what you can write off with a second home and an investment property[6]:

  • Mortgage interest: As of 2018, you can deduct up to $750,000 in mortgage interest on all your mortgage debt, including your primary residence, second home and investment property.
  • Property taxes: You can deduct up to $10,000 in state and local property taxes for each property.
  • Mortgage insurance: If you’re paying private mortgage insurance (PMI) on a second home, it’s currently deductible.

You can also write off maintenance, advertising, management fees and utility bills with an investment property. Those write-offs can help offset your rental income, so you’ll owe less in taxes.

Whether you’re buying a second home or investment property, take the time to talk to a tax professional and learn about all their potential benefits and liabilities.

Is a Second Home or Investment Property Right for You?

Buying a second home or investment property can be a rewarding way to generate passive income and invest for the future – but it’s also a big responsibility and can be a big financial risk. 

Before you start looking at second homes and talking to lenders, take a hard look at your finances and see how much you can realistically afford to spend. 

If you’re looking at an investment property, make sure and do your homework. Is the property in good condition? Do you have enough time and money to invest in fixing it up? Get those questions answered so you can get a decent return on your investment.

  1. Internal Revenue Service. Topic No. 415 Renting Residential and Vacation Property.” Retrieved November 2021 from https://www.irs.gov/taxtopics/tc415

  2. Fannie Mae. “Lender Letter (LL-2021-16)” Retrieved December 2021 from https://singlefamily.fanniemae.com/media/30196/display

  3. Fannie Mae. “ELIGIBILITY MATRIX.” Retrieved November 2021 from  https://singlefamily.fanniemae.com/media/20786/display

  4. Fannie Mae. “Loan-Level Price Adjustment (LLPA) Matrix.” Retrieved November 2021 from https://singlefamily.fanniemae.com/media/9391/display

  5. Internal Revenue Service. “Net Investment Income Tax.” Retrieved November 2021 from https://www.irs.gov/individuals/net-investment-income-tax

  6. Internal Revenue Service. “Real Estate (Taxes, Mortgage Interest, Points, Other Property Expenses) 5.” Retrieved November 2021 from https://www.irs.gov/faqs/itemized-deductions-standard-deduction/real-estate-taxes-mortgage-interest-points-other-property-expenses/real-estate-taxes-mortgage-interest-points-other-property-expenses-5

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In Case You Missed It

Take-aways

  1. Lenders charge higher interest rates for a second home or investment property because they know homeowners tend to prioritize their first homes for payments if things go bad
  2. If you borrow against your primary residence to make a down payment on a second home or investment property, your lender will usually limit your CLTV to 75% – 80% of your home’s value
  3. If you buy a second home or investment property using a conventional loan, you’ll need to conform to the loan limits set by Fannie Mae and Freddie Mac

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