You may have heard the terms "second home" and "investment property." But what do they mean? How are they different from a primary residence? And how do they differ, both in function and financing?
There's generally a lot of confusion around the two. After all, not everyone knows technical terminology like that. But don't worry. In this guide, we'll pin down the differences between a second home vs. investment property.
What Is a Second Home?
A second home is a real estate that you own but do not permanently reside in. Despite this, you must live in the home for a certain period, and you mustn't use it as your primary renting property.
What Is an Investment Property?
An investment property is a property that you own for renting out to other people. Investment property owners can still use it for personal use. But it shouldn't be the primary purpose of the property.
Additionally, you can buy an investment property to earn returns on a future resale. You can also buy the property for returns on both anticipated rental income and future resales.
Is It Wrong to Claim Your Investment Property as A Second Home?
Since there's a massive difference between the two, it is wrong to claim one as the other. Many people do so to avoid getting charged high for tax purposes. But it's illegal.
However, that isn't to say that a second home can't become an investment property and vice versa. The IRS sets down a few rules for a property to be considered a second home.
Keep in mind that the number of days to live in the second home in the rule above must be the one who is more significant between A and B (i.e., in the example above, 14 days is more significant than ten days).
If you do not meet this requirement, the IRS will not consider it as your second home. Keep in mind that it is illegal to trick your lender. Some people make the lender think that their investment property is a second home. Many people do this to get lower mortgage interest rates and down payments. It is called occupancy fraud and is considered a crime.
Second homes also differ from investment properties in their tax and lending implications. These are:
Is It a Second Home Loan or Investment Property Loan?
Although you can rent out your second home, many loan lenders won't accept any form of renting. So instead, you must use the property solely for residential purposes.
For this reason, it's better to apply for an investment property loan if you plan on renting the home out for some time.
It's crucial to know the differences between the two. That is especially the case when taking a loan for a second home vs. investment property. Be sure to state which loan you are applying for so the lender gives you the right one.
Don't try to apply for a second home loan but use it as an investment property. If your lender is experienced enough, they can sniff out mortgage frauds. The mortgage company might even send someone over to check if you're living there.
Tips For the Second Home Owner
Ready to purchase a property as a second home? Here are six helpful tips to help you buy your first, second home.
Choose A Location Wisely
Always look for a location that you can easily access from your primary residences. Also, ensure that it's close to basic life amenities such as food shops and restaurants. Don't choose a very remote location secluded from society for security purposes.
However, remember that some jurisdictions may require the home to be a certain distance from your primary home. Otherwise, it won't count as a second home.
Also, ensure the location is perfect for your vacation. A decent view, lots of activities, and a furnished interior – in other words, imagine the perfect weekend and make it happen.
Next, it's a good idea to decide what you'll be using the property for when you're living in it. For example, if it tends to get cold where you live, you can choose a second home in a warmer climate.
Consider Financing Options
It may seem more convenient just to pay the total price upfront and be done with it. First, however, it's a good idea to talk to a mortgage advisor who will walk you through the right personal financial plan for you. Then, you can opt for three financing options: conventional loans, fix-and-flip loans, and home equity loans.
Conventional home loans are generally issued long-term (15-30 years) based on a borrower’s personal credit history and property value.
Fix-and-flip loans are issued for a 12 to 18 months period. They are designed to help a real estate investor to renovate a property.
In contrast, a home equity loan is a fixed amount of money secured by your home. The amount you can borrow is limited to 85% of the equity value of your home.
Even before all that, consider not just the property's price but property taxes, resort fees, and assessment fees as well. You may also have to predict repairs and management costs. And of course, keep the insurance fee in mind too.
Look For Furnished Properties
It may be better for you to buy fully furnished real estate. Don't be afraid to invest in a suitable property that won't require any furnishing or additional construction work. These properties cost more, but you'll be doing the hard work yourself anyway if you buy an unfurnished property. And think about it - the better the house is for you, the more attractive it'll be to potential renters.
It's essential to put your priorities first. But since you'll be generating income through rents, sometimes you should put the tenant's needs in front of you. Consider adding themes to the property that are popular. Perhaps add a few indoor games (for example, a pool table) that interested parties are sure to play. Then, with time, make the proper renovations to your property to make it welcoming to guests.
Hire A Property Management Team
Who says you can't take care of your second home yourself?
Even if it's not a big or lavish home, you don't want to be doing chores during your vacation. And what about the rest of the year when you're not living in the property? Hire an excellent reliable management team that guarantees your home will remain in pitch-perfect condition.
Know your way around the market. Ask other people and your advisor about which companies are good to hire. Never settle for anything less than your standards. Remember that the property management company isn't just managing it for you. They're also managing the real estate for your tenants. You don't want the tenants to open the doors to a dirty, unkept interior.
Get A Trustworthy Advisor
Choose your realtors and lenders very carefully. The right realtor can make all the difference. These are the people that will guide you through the process and help you make the best decision for yourself. Rely on them to choose the right vacation property for you and sell it to tenants.
Don't Miss the Opportunity.
Lastly, don't wait too long to purchase a house. Yes, you should be very careful and think ten times before finalizing a purchase. But if you wait too long, the property may not be available anymore.Always incorporate time into your thought process. You don't want to ponder buying a second home only for the property to be taken by someone else. Maintain a good credit score, and suitable properties will come to you.
Second Home Investment Property Financing Methods Are Different
One of the biggest questions that people have regarding a second home vs investment property is the financing. Second-home and investment property financing methods are different.
It entirely depends on the lender, but interest mortgage rates for second homes and investment properties are not the same.
Say you're settling for a 20% down payment for the property. You will be charged a lower interest rate if you're purchasing it as a second home investment. However, if you're purchasing it as an investment property, the interest rate will be slightly higher. And yes, that's for the same down payment.
In this case, down payment and interest rate have an inverse relationship: the more down payment you pay, the less the interest rate for you.
Additionally, most lenders have lower down payments for second homes. Most lenders allow down payments of 10% or higher for second homes. However, with investment properties, they won't settle for anything less than 25%. The interest and tax rates for primary residences are much lower.Again, this varies widely with the lender. But these are the estimates for the American real estate market.
Tax Implications of Second Homes and Investment Properties
Not only is the financing different for second homes and investment properties, but the tax implications are too.
Second homes can apply for mortgage interest tax deduction. You can use this tax deduction on the interest you paid for up to $750,000 in qualified residential debt. It's a different case if you have an investment property, though. Then, you can deduct the amount of interest you paid on your mortgage, but only if you deduct it as an expense that you incurred against the rental income you made.
Investment property owners can also apply for an annual depreciation expense claim. It will lower the taxable rental income. The downside is that you get a higher tax bill on the home’s sale if you do that. That's in part due to the depreciation recapture tax.
How Mortgages Differ for Second Homes and Investment Properties
Investment property mortgage rates generally run higher than those for second homes. You may be charged 0.50% to 1.00% higher in investment property mortgages than you would for a second home.
Additionally, second homes and investment properties have higher interest rates. It is also because you are less likely to abandon your primary residence than your second home. In comparison, investment properties have higher interest rates than second homes. And that's even for the duplicate mortgage payments.
How Do I Finance a Second Home or Investment Property?
When it comes to financing a second home or an investment property, you have quite a few options.
Your first option is to get a conventional bank loan. However, unlike with your primary residence, you may be charged a down payment of up to 30%. That is, if you're financing an investment property. The down payment will be lower for second homes.
The second option for you is a fix-and-flip loan. Flipping is the practice where you purchase a house for certain mortgage payments, then sell the house for higher. Often, you'll do some extra renovation work to make the house worth the higher price. A fix-and-flip loan lends you money to complete said renovations. But these loans don't come cheap, and mortgage interest rates can be as high as 18%. Also, you're often required to pay back the money in a shorter period.
Your third and final option is using your home equity. Home equity is the price of the home minus the mortgage debt. In other words, it's how much you've already paid for the property. You can either take a Home Equity Line of Credit (HELOC) or a one-time loan. HELOCs allow you to borrow from your home equity. The best part is that the monthly payments are interest-only. The downside is that you end up paying longer for the mortgage.
Should I Buy a Second Home or Invest in An Investment Property?
Essentially, it all comes down to what you want. Most second homes are used as vacation homes. If you want to buy a property in some resort of your choice for your family to visit, choose a second home. If, however, you need the property solely to generate rental income, buy an investment property.
If you're worried about upfront pricing and interest, then a second home is the better option. Second homes have lower down payments and interest mortgage rates than investment properties. Besides that, they have higher interest rates than a primary residence. However, you mustn't commit occupancy fraud. Most mortgage lenders are very experienced in noticing this, and you could end up losing a decent property if you’re not careful about this.
Second Home Vs. Investment Property FAQ
See the most asked questions
Second homes are better financing-wise. They require lower down payments and have a lower interest rate. You also pay lesser property taxes and get higher long-term profits. Plus, if you've got your investments elsewhere, investing in a second home is a great way to diversify your investments. Besides that, second homes make great options for vacationing and spending quality time with your family.
The interest rate on a second home is lower than that on an investment property. But it's higher than that of a primary residence. The reason is that you're less likely to abandon a second home that you use for vacationing than an investment property.
It depends on what the mortgage lenders ask for. But yes, in most cases, you're required to pay at least a 20% down payment. It is usually the case if your credit score is lower or your debt-to-income ratio is a lot higher. If you don't have the 20% down payment, you can also get the mortgage by paying Lenders Mortgage Insurance (LMI). You can also use the equity of your home. But, again, this depends on what the lender accepts.
People tend to get confused between second homes and investment properties. But hopefully, by now, that confusion would have died down.
To conclude, a second home is a residence where you don't live permanently. Instead, you live in it for a certain period and then use it as a rental property. Investment properties can only be rented out and not used for personal residence.
It all boils down to what you need. Ensure that you get the right type of loan from your lender, as well as consult a reliable advisor to guide you through the way.