When someone is at that point in life where he can finally afford to buy a vacation home, considering a few things is critically important to make the right decision. And here we’re not talking about the type of home he should purchase but about all the financial aspects that can turn his life upside down if ignored.
Whether it’s a peaceful lakeside hideaway, a rustic mountain cabin or a charming beach house, a person who’s about to buy a vacation home should consider three major aspects: second home loans, refinancing and tax deductions. Now, let’s discuss each of these points in detail.
- Second home loans – A person with substantial equity in his property can opt for a second mortgage, also referred to as home equity loan. The home equity loan, which allows home buyers to borrow a lump sum, should not be confused with the home equity line of credit (HELOC), which provides continuous access to funds. Though second mortgages are a good option for buying a vacation home, they involve higher interest rates, larger down payments than 20 percent, which is typically associated with conventional mortgages for primary residences, and stricter standards for credit scores, ranging from 680 with a 35 percent down payment to 740 with more than 20 percent down payment. In addition, the total loan amount cannot exceed 80 percent of the property value. Since most creditors don’t approve home equity loans that drain too much equity from the principal residence, the homeowners who have lost equity due to the decline in the market value of their properties may not qualify for a second mortgage.
- Refinancing – Purchasing a vacation home often means handling two mortgages at once. Sometimes, a better alternative is to combine first and second mortgages into one through refinancing. Though some financial experts advise against refinancing, combining two mortgages can be a great financial move when purchasing a second home. That’s because it brings two benefits: a fixed interest rate and a lower monthly payment. But one major downside of refinancing is that it almost always resets the payment schedule. Because a large amount of payment goes towards the interest in the first few years, resetting the payment schedule may cost borrowers more in the long run. Considering all these, mortgage refinancing makes financial sense only when the total amount a borrower will have to pay on the loan is lower than the total amount of the two separate mortgages.
- Tax deductions – Before buying a second home, it’s essential to know that interest is tax deductible on mortgages up to $1 million (joint tax return) or $500,000 (individual tax return). In addition, the taxes a person must pay on a second home and how much of those taxes can be deducted largely depend on whether the property is used as a vacation or rental home. As an example, a homeowner doesn’t have to report and pay taxes on rental income if he rents out his home for up to 15 days a year. When the home is rented for more than 15 days, it is considered a rental property. In this case, the rental income must be reported, but the homeowner can deduct rental expenses like cleaning and maintenance. The best way to understand all the tax implications of getting a vacation home is to check the Topic 415 on the IRS website or consult a tax professional.
Since buying a vacation home takes careful planning and budgeting, reviewing the financing options available for second homes and considering the tax implications before making a final decision is very important.