There are many reasons why current homeowners may be looking to purchase additional properties. The classification of these additional investment properties is important to understand if you are considering buying another home. Taking on an additional mortgage is a huge burden financially, so only homeowners who are in stable financial situations should consider this step.
One question that you should answer before you even start looking at other properties is this: What is the primary purpose of this property? The two primary categories of additional properties are second homes and investment properties. You will need to decide which category your next property falls into. Even though the terms second home and investment property are often used interchangeably, they are not the same thing.
What is Considered a Second Home?
A second home is a single-unit property that you intend to use for personal enjoyment as a personal residence. If your plan is to live in this property for up to six months of the year without it being your primary residence, then it is most likely considered a second home. A second home is often another name for a vacation home.
For example, if you live in the state of New York and want to buy a house down in Florida to enjoy the warmer weather at certain times, then this would probably be classified as a second home or vacation home.
What is Considered an Investment Property?
An investment property is very different from a second home, even if it shares some similarities. The key difference is that you are buying the investment property to make money. You could be making money from rental payments from tenants, from flipping the house for profit, or even from certain tax benefits that come with it.
As an example, you might purchase a home nearby if you live in a popular tourist destination. If you buy that home to rent out to short-term guests, like an Airbnb, then this is considered an investment property rather than a second home.
Pride Lending recognizes the challenges that marginalized people face when they purchase investment property. Homeownership rates amongst LGBTQ+ and BIPOC individuals are much lower than their white, cisgender, heterosexual peers; for example, only 49.8% of LGBTQ+ individuals own a home as compared to 70.1% of their peers. LGBTQ+ individuals are less likely to have higher credit scores, which are essential for purchasing a commercial property.
White Americans make up 88% of homebuyers, with Black Americans making up just 3%. Additionally, only 3% of Black households own non-residential real estate, meaning they are missing out on significant opportunities for generating income.
We aim to serve as advocates for BIPOC and LGBTQ+ investors, ensuring they have the same opportunities to join the real estate market and overcome the institutional challenges they face.
Financial Impact of Second Home vs Investment Property
Whether you are buying a second home or an investment property, there is a significant financial impact on your life. The following elements will affect the financial implications of purchasing a second home or investment property.
Down Payment Requirements
The down payment is the amount of money you pay upfront on the purchase price of the property. It affects the total loan amount as well as the monthly payments. If you plan to use a conventional loan to purchase the property as a second home, the minimum down payment will likely be 10%.
For an investment property, many mortgage lenders will require down payments of 15% for a 1-unit investment and 25% for a 2-4 unit investment property. This is because lenders understand that with primary residences, individuals will be reluctant to let go of the property, but business owners will not be as attached to their homes; as such, they consider an investment property mortgage to be higher risk.
Typically, larger down payments from buyers make for an easier approval process, so the more cash reserves you have, the better.
However, you do have some options to reduce how much you need to put down. For example, FHA loans are available for home with up to four units; this means that you can use one unit as your primary home and then use the rent from the other units to pay off your mortgage debt, utility bills, and other expenses. An FHA loan requires a minimum down payment of 3.5%. However, those with a lower credit score between 500 and 579 may need to put 10% down.
Mortgage Interest Rates
If you want to know how to determine mortgage rates for your second home or investment property, you will likely have to get quotes from individual lenders like Pride Lending. The type of loan you use will impact the interest rate.
Taxes
There are numerous tax implications to consider surrounding investment properties and second homes. Both properties are subject to property taxes to the local municipality. With a second home, you can deduct mortgage interest from your taxes. However, an investment property has far more tax benefits and tax implications to think about.
For example, assume that you have a vacation property that you don’t use all year. You occasionally rent the property out as an AirBnB. The tax rules now change, as you have converted the home into an investment.
Renting for 14 days a year or more makes the rental payments taxable income. You can deduct interest as a business expense to lower the tax bill as well. An investment property can also involve tax deductions for other expenses that would be considered personal expenses if the property was a second home.
Understanding the tax implications of a second home vs investment property is crucial when deciding which type of property to purchase. Always be mindful of your total property taxes when making a major commitment like this. It’s always a good idea to talk to a financial advisor about the best options for your property in relation to tax purposes; an accountant can also help double-check your tax return and ensure that you haven’t made any expensive mistakes.
You will also want to consider what happens when you decide to sell the property. In general, unless you buy a similar property within a set time period, you will need to pay capital gains tax, which is a percentage of the profits. Short-term capital gains is typically much higher than long-term capital gains, so it pays to hold on to a property for at least a year.
Potential Rental Income
Buying a rental property is a great way to generate income. Often, investment properties can generate enough money to cover the mortgage and other operating expenses and put profit in your pocket. Generating rental income qualifies that home as an investment property unless you rent out the home for less than 14 days a year. In that case, it could still be classified as a second home rather than a vacation rental or long-term investment property. If you rent out a second home for more than 14 days, then you have to report rental income for federal taxes to the Internal Revenue Service.
Ask a tax professional if you have any questions about property taxes or tax implications for rental income.
Return on Investment
Buying any type of property, whether it is a second home or investment property, is an investment in the future. You build equity as you pay the mortgage, and eventually, that equity can benefit you financially. With an investment property, you are also making money from rent or flipping the house for profit. Return on investment for a second home is going to be a long-term strategy and depends on how much the home initially costs, how much money you put into it, and what it sells for.
An investment property has a different type of ROI. To calculate ROI for your investment property, you simply divide the annual return by the original out-of-pocket expenses. For a flipped home, you add the price of the home when you bought it to the improvement costs. Then, you subtract that number from the final sale price. You also have to account for closing costs and any capital gains taxes on the transaction.
Usage and Occupancy of Second Home vs Investment Property
Since neither type of property is a primary residence, occupancy requirements are different for a second home and an investment property, and they will also impact loan qualification. Technically, you do not have to occupy the second home at all, though you would need to live in it for at least 14 days out of the year to deduct mortgage interest. If the property is occupied by renters for more than 14 days each year, then it is classified as an investment property.
The type of loan you can acquire will depend on the usage of the property. For a second home, you would only need an additional homeowner’s insurance policy. However, the property is at greater risk if it is being rented, so you would need rental property insurance for an investment property.
It’s crucial to be honest about the purpose of your property when purchasing, as lying on the application in order to obtain better rates is considered mortgage fraud.
Property Management
How the property will be managed is important specifically when buying an investment property. You can either manage the rental yourself and handle all tenant relations, lease agreements, and maintenance, or you can hire a property management company to do all that work.
If you have property management experience, you can handle the burden yourself, though it will require more work since you are the landlord and property manager. Hiring a company to manage the property is a far more passive strategy.
Rental Restrictions and Regulations
You cannot simply buy any property you want and have it generate rental income. Often, there are local restrictions that limit what properties can be used for rental income, such as homeowner’s associations or governments. There could also be limitations on short-term rentals versus long-term rentals.
Numerous jurisdictions have passed laws banning short-term rentals, such as AirBnBs, in order to help locals afford property. One major example is Hawaii, which intends to phase out short-term rentals entirely. Being familiar with the local legislative landscape can help prevent unpleasant surprises when you attempt to set up your business.
Other Factors You Should Consider
If you are interested in a second home or investment property, the financial implications and usage of that property are not the only factors to consider. Here are some other elements that should play a major role in your purchasing decision.
Location
Where is the property located? You should research the local market to determine whether this property should be a second home or an investment property. For example, is there a lot of appreciation potential in the market? Is demand for rental properties high in this area? If so, then it might make more sense to purchase an investment property to generate income. You can always block out some booking dates to occupy the property yourself for a temporary vacation home in a resort or vacation area.
Location will also impact the types of home loans and investment property loans you can acquire.
Property Maintenance and Upkeep
Owners are responsible for taking care of their properties. This is a burden you must consider before buying a second home or investment property. Will you manage repairs yourself or pay a contractor to do so? If you plan to make upgrades to the home for yourself or your tenants, then that is another cost to consider.
Maintenance and upkeep tend to cost about 1% of a home’s value each year, so plan accordingly. This is especially important for investment property owners.
Insurance Requirements
If you plan to rent out this property, then you will need to pay for better insurance policies. This could include rental property insurance and landlord insurance. For a second home, all you will need is another homeowner’s insurance plan.
Make sure you factor these specific insurance policies into your budget when choosing between a second home and an investment property.
Exit Strategies
You should never buy any type of real estate without considering the long-term implications of ownership. For example, are there positive market conditions that would allow you to get a good resale value if you want to offload the property?
What’s the plan if your investment starts becoming a heavy financial burden and you have to sell it quickly to save money? Is the long-term plan to sell the second home or turn it into a rental? In the future, you may also consider taking out a home equity loan on the property in order to purchase more investments; its overall performance will influence how quickly you can expand your portfolio.
Consider your exit strategy whether you are buying a second home or an investment property.
Choosing the Right Path for You
When assessing the benefits of a second home vs investment property, the most important consideration is your purpose for the property. Whatever path you choose, it should be the one that is best for your specific situation.
Assessing Your Financial Goals
If your financial goals for the property are to build wealth over time, then investment properties are the way to go. However, a second home is a superior choice if you simply want a change in your lifestyle and have the money to afford it. You should understand your own risk tolerance before deciding between the two.
Personal Preferences and Lifestyle
The purpose of the property will impact your lifestyle for years to come. Rental income can supplement your primary income to give you a more luxurious lifestyle, especially if you can afford a property manager to handle the daily tasks. However, if you just want a vacation home for your family to enjoy, then a second home removes that extra burden of managing a rental home.
Summary
Second homes and investment properties may change your financial situation quickly, but they offer additional opportunities that a primary residence cannot. Whether you want a vacation home in another state to enjoy or need supplemental income from a rental unit, deciding which one is the right option depends on your preferences, personal finances, and lifestyle goals.
If you need help finding another property in addition to your primary residence, Pride Lending can help. We have a fierce commitment to helping all borrowers, no matter their identity, find the perfect home mortgage product for their needs.
Our team is composed of allies and members of the LGBTQ+ and BIPOC communities; our experts can walk you through the investment property mortgage process and ensure that you’re fully familiar with all that it entails. Most importantly, we will serve as your advocate and ally, matching you to programs that can help you achieve your dreams.
We’ll help you decide between investment properties and second homes based on your needs and walk you through the complexities of finding the perfect mortgage loan. Call our team today at 725-231-0192 to start a conversation.
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