The biggest investment most people will ever make in their lifetime is their personal residence. Buying a home is a rite of financial passage for many. It means breaking the bonds of paying rent to someone else and paying yourself by building equity of your own.
But what about buying a second home — say, a vacation home? Is it a good investment?
As with so many other financial decisions, it depends on your personal preferences, long-term goals and current financial situation. Here are five things to consider before buying a second home… and an alternative if you decide this isn't for you.
“Location, location, location” is always a key factor when it comes to real estate. You can’t physically move the house to a better location if you choose poorly!
If you’re buying a property where you intend to vacation each year, you’ll want to be sure that the location is one you’ll enjoy for years — not just a few seasons. And make sure that you’ve considered everything about the location you choose.
Do you like the peace and quiet of a mountain cabin, even if you happen to get snowed in extra days because of an unexpected winter storm? Or do you prefer a beach condo, even if unruly Spring Break teenagers occupy the unit next to yours the week you decide to take your family? Or maybe a resort property in Nicaragua fits your style — until you realize that you can’t find needed supplies or competent English-speaking help to keep the property up and running because of its remote location?
You’ll also want to understand the history and planned future for the specific property and general area to determine a reasonable estimate of the property’s appreciation potential. Connect with a local real estate agent to understand these factors and more, including potential zoning proposals that could negatively or positively affect the property’s future value.
Vacation homes tend to be located in desirable places where people want to visit. These areas often experience market appreciation simply because of their desirability. But you have to be careful. Real estate values can vary widely even in these seemingly bubble-insulated locations. A season of devastating hurricanes hitting the same beach town can do so much damage that the local economy will take a decade or longer to recover.
Your choices are nearly limitless. A waterfront cottage on the bay. A secluded lake property surrounded by miles of hiking trails. An urban apartment close to world-class shopping. A mountain cabin with game for hunting. A beach property with sun and fun for the family. A ski resort condo. A house on one of the Caribbean islands. Or even a suite in a popular tourist destination like Orlando or Vegas. Whatever your destination, you might consider renting for a few seasons in the area to make sure you’d be happy there long term.
Can you afford a second home? Even if you can, are you ready to sacrifice on other things you might otherwise afford if you don’t buy the second home?
Real estate is a long-term investment choice. There are the high transaction costs of buying and selling to consider. And by nature, real estate investments are not liquid assets. It takes time to sell. You can’t decide today that you want to sell and have the cash in your bank account next week or even next month.
So you’ll need to accurately estimate the purchase price you can comfortably afford. And you need to carefully tally the total cost. Of course, you have the normal costs of maintaining a home. Wear and tear is inevitable. And appliances break. On top of that, you have monthly utilities, annual property taxes, HOA or condo fees and insurance coverage, to name the biggest expenses.
Vacation or second homes can have additional costs to budget for. There are property management fees, liability insurance and activity fees. There are periodic cleaning costs between tenants if you’re renting. If your new place has a pool, there’s the cost of winterizing and other maintenance costs. And don’t forget flood or hurricane insurance and a security monitoring system. Also, you may plan on vacationing at the property or regularly checking on it. So you need to budget travel expenses to get there and back.
I have friends with a vacation home on St. John in the Virgin Islands. It’s beyond lovely, but it’s also very expensive to get to. And since it’s an island, all consumables arrive by ship. So groceries and gas are extremely expensive while you’re there. Properly planned for, though, these costs will not be a surprise.
Remember, real estate is a long-term investment. You want to feel secure that you can afford to own it for more than a few years. If you’re a married couple with two incomes planning for one parent to stay home when you have children, be sure you can afford the second home on one income.
#3: The Mortgage
Assuming that you don’t have enough cash sitting around to buy a second home, you’re going to need to get a mortgage.
To see if you qualify, you’ll need to know your debt-to-income ratio, or DTI. This is how much you owe in relation to how much you earn. Most lenders don’t want a buyer’s total debt to exceed 36% of their income.
Here’s how to get a good estimate of whether a second home will put you over the limit or not. Add your current mortgage payment and the anticipated second mortgage payment and then divide that number by your monthly income before taxes. Don’t include the amount in your monthly payment that pays taxes and insurance if those are figured into it.
Let’s say, for example, your current mortgage payment is $1,500. Your second home mortgage payment would give you an additional mortgage payment of $1,300. And your annual income is $90,000. Your DTI would be 37%. That would be a little too high for most lenders to approve.
Also, you will need to have a higher down payment saved for a second home. It’s not unusual for lenders to require down payments of between 25% and 40% on second home or vacation property loans. Before you start looking at a certain property price range, be sure you’ve realistically saved enough for the down payment.
There are two more mortgage considerations. You will likely need a higher-than-average credit score to qualify for a second mortgage. 725 is typically the minimum credit score lenders will consider. And interest rates on second home loans are typically slightly higher than the rates for primary residences. Maybe the difference between 3.5% and 4.5% doesn’t seem like much. But over the course of a 30-year mortgage, that difference can be hundreds of thousands of dollars.
One of the main reasons people consider buying a vacation home is to have the freedom to go to a place they enjoy whenever they want. You don’t need reservations. You have the key. You can pack light because you keep extra clothes at the property. And the pantry there is already stocked. You know you’ll like the location and accommodations because you personally chose both!
Thinking long term can help you make an even better choice. Many people plan on eventually retiring to their second home. If that’s your plan, it opens up a whole new set of parameters to consider. And decisions to make.
You’ll want to make sure the layout and location of the home will fit your retirement needs. A four-story urban townhouse might have too many stairs for when you’re 65 years old. That remote home in Nicaragua may not have access to the quality of urgent health care you may need in your golden years.
#5: Rental Income Potential
You can offset some, or in some cases all, of the costs of owning a second home by renting it out. You can do this for short-term stays if your property is located where vacationers would want to visit. Or rent it longer term if you’ve purchased the property as your retirement home but haven’t retired yet.
Your vacation home will likely be a place others would also want to visit. So you can charge premium rates for your rental. You need to keep in mind, though, that the cost of buying and maintaining a vacation rental property is typically more than that of a regular rental property. And there’s an off season during which you’ll have high vacancy (and lower rental income if you are able to rent it at all).
It’s wise to hire a reputable real estate agent or property manager to screen and place renters as well as handle the financials. Or if you’d like to be in complete control and manage it yourself, the online Airbnb model is becoming very popular. Of course you’ll want to make sure you consider the tax implications of whatever choices you make. Liability concerns can be addressed with a competent insurance agent.
Is There an Alternative?
If you've decided that perhaps owning a second home isn't for you — but if you're intrigued by the idea of investing in real estate, there are several great online platforms that offer unique ways to get in on this market. Investor Junkie regularly reviews the most popular real estate crowdfunding platforms. Our favorite platforms are Fundrise and Realty Mogul.
In summary, buying a second or vacation home is a big decision. Like any other real estate investment, the numbers have to work and you must do proper due diligence. Ideal summer vacation homes — the ones that are the perfect distance from amenities, the right size and in good neighborhoods — can be in high demand. So it’ll likely take time and patience to acquire one at the right price.