The pandemic and subsequent lockdowns have caused more people to look for a permanent escape from the monotony of life at home. Many have flocked to sought-after vacation destinations like Florida, California, Colorado and Arizona for more access to outdoor living or winter sports. According to an analysis from real estate firm Redfin, demand for second homes doubled in October 2020 from a year earlier. With all-time low interest rates, buyers may be thinking this is the perfect time to make the plunge and purchase a vacation home to set up for a happy post-retirement life.
As an advisor, it’s important to ensure that your client is ready to take this exciting step and understands all the considerations that go into buying a second home, particularly if they’re entering their golden years.
Ensuring Your Client’s Second Home is Truly Away from Home
If a client makes the decision to purchase a vacation home, it’s important to first make sure they understand the true definition of a vacation home, in the eyes of a lender. The new home-away-from-home must be truly away, as lenders want to be sure that any secondary residence is at least 50 miles from their primary one. If it’s any closer, it will probably be classified as an investment property, which comes with different tax burdens.
Preparing Them for a Steeper Down Payment
Buyers may have put down as little as 5% for their primary residence, but it’s a different game with vacation homes. It will vary, but they’ll likely need an upfront payment of 10% to 20% and will need to meet more stringent credit standards. Be sure to take into consideration that any down payment will detract from their retirement savings and ability to use those funds for living expenses.
Calculating Income
If your client is retired, lenders will use their pension, Social Security and required minimum distribution from their IRA to calculate their income. For borrowers with large investment portfolios, some lenders may use asset depletion to calculate additional income. Asset depletion assumes that clients will withdraw assets from these accounts over the term of the loan. The borrower is not required to cash in their assets as this is only used to show that they are able to repay the mortgage.
Understanding Financing Options
There are three distinct ways homeowners can finance a vacation home, each with different factors to consider. It’s important that your client understands each option and works closely with a lender to determine which option is best for them.
Traditional Mortgage
The first option is a traditional mortgage, which will allow them to fix their monthly payment with principal and interest payments over the term of the mortgage, like they did with their primary home.
Home Equity Loan/Line of Credit
Equity is at an all-time high, and many retirement-age individuals have likely built up a good amount of equity after paying off their primary mortgages over many years. As such, a home equity product may be a good option for your client. However, it’s important for them to know that home equity loans typically have higher rates than a traditional mortgage, but no closing costs.
A home equity line of credit (also known as a HELOC) has a variable rate that may be okay for the short-term, but borrowers should keep in mind that rates can rise over time, making the payment more challenging. This may be a good option for clients looking to sell their primary residence and transition into their second home as they’ll pay very low closing costs and interest only until they sell their primary residence.
Cash-Out Refinance
Your client may be able to complete a cash-out refinance on their home and use those funds to purchase the second home. When considering this option, they should compare it to the traditional purchase mortgage options in terms of down payment and interest rate.
Getting Familiar with the Tax Laws
Tax laws should always be taken into consideration when making a home purchase, but there are different considerations for second/vacation homes, and prospective buyers must do their due diligence and research the tax laws that apply to their purchase.
The Tax Cuts and Jobs Act of 2017 made some significant changes that may affect owners or purchasers of luxury homes. The new rules limit things like deductions of mortgage interest and property taxes, as well as deductibility of interest on home-equity loans, HELOCs and second mortgages — loans that some homeowners may use to tap the equity on their primary residences to pay for vacation homes.
Additionally, federal tax rules offer deductions for many expenses on second homes, like mortgage interest, property tax and insurance premiums. However, those rules can be very complex and have strict stipulations about who qualifies for them. Therefore, it’s important to ensure your client understands the tax laws that apply to purchasing a vacation home in their state.
Considering the Costs of Maintaining a Vacation Home
A vacation home is just that — a home you own and escape to occasionally, not permanently. Your client will need to consider the cost of maintaining or potentially renting out the home when they aren’t there. Renting can be a great way of offsetting their mortgage payment, but it comes with its own expenses, particularly if they need to hire professionals to manage the property. And even if your client doesn’t rent the property, it still needs to be maintained and they’ll need to consider the additional costs such as a property manager, landscaping and unexpected repairs.
Consult the Experts
If your client has come to you about their plans to purchase a vacation home, they’ve made a great first step to ensuring the process goes smoothly. Their next step should be consulting with a mortgage lender with expertise in financing vacation homes.
Many buyers wait too long to speak with a lender, delaying the conversation until after they have found a home. However, it’s important for your client to engage as soon as possible to get a full picture of their financial situation, particularly as vacation-home buyers are in many cases high-net-worth individuals with complex financial situations. In this regard, financial advisors and lenders can work together to ensure clients are set up for success with their new dream home.
Scott Lindner is national sales director for mortgage lending at TD Bank. He is accountable for leading TD’s mortgage loan officer salesforce. His other responsibilities include guiding sales strategy, product development and integrating with TD’s East Coast retail network.
