Mar 30, 2004
Second homes aren't only for rich people. They have become mainstream, whether they're used for vacations or for rental income.
More than 9 million dwellings in this country are second or third homes, accounting for about 6 percent of residential sales. Three-quarters are considered vacation homes and the rest are investment properties or undeveloped land, according to a 2002 survey by the National Association of Realtors.
You don't have to have a pile of cash on hand to buy a vacation house. You can use the equity in your primary residence to help pay for a second (or third) home. Make sure you explain to your lender what you're doing, and you might want to consult with a tax adviser, too.
"There are so many variables, so many moving pieces," says Anthony Hsieh, president of HomeLoanCenter.com. "But the high-level perspective is you need to see how much equity you do have in your existing home and what are the benefits of pulling out equity in your existing home vs. borrowing. It's always about the cheapest cost of borrowing."
It's not always easy to identify the cheapest cost of borrowing, and that explains why communication is so important. The lender needs to know which house will be your primary residence and which will be secondary. In most cases, you will find that the interest rate on an owner-occupied home will be about three-eighths of a percentage point lower than for a nonowner-occupied house. With today's low rates, that means you might be able to get a loan for 5.5 percent on your primary residence and have to pay 5.875 percent on the loan for the second home.
"That argument automatically gives you more motivation to get as large of a loan as possible on your primary residence because it's the cheapest cost of borrowed money," Hsieh says.
Equity is equity
Many borrowers resist this line of reasoning because they want to build equity in the home they live in. It seems instinctually like the smart thing to do. "But in reality, equity is equity -- it doesn't matter which house," Hsieh says.
So if you have a lot of equity in your primary residence and you want to buy a vacation home, it might make sense to refinance the mortgage on the primary home for more than the current loan balance. That's called a "cash-out refi" because you borrow more than the current balance, pay off the current loan and get the remainder in cash. You can use the cash extracted from your primary home's equity to make a down payment on your second home, or even to buy it outright.
For some homeowners, the cheapest cost of borrowing isn't only about borrowing as much as possible at the lowest interest rate. It's also about taking advantage of tax deductibility.
Take, for example, a newly married couple in which both spouses come into the marriage owning their own homes. They want to keep both houses -- renting them out -- and buy a third house as their primary residence.
Tax deduction limits
"The trouble these people will run into is that a third home is not tax deductible," says Dave Herpers, director of consumer affairs for mortgage lender Amerisave. "Therefore, a third home is an investment property." In fact, in the above example, the spouses' original two homes are transformed into investment properties, which means that the owners must contact their lenders to tell them that the use of the property has changed, Herpers says. "That lender would make the judgment call whether they have to change the documentation surrounding their loan or refinance it."
If the owners must refinance, they move into complex territory. They want to maximize the size of the mortgage on their primary residence to take advantage of a lower rate and tax deductibility, while refinancing the loans on the other two houses. This can require delicate timing, if only to ensure that they qualify for all the loans.
The cash-out refi shuffle
There is also the sensitive matter of staying within the letter, if not the spirit, of the loan documents by engaging in creative timing. In some cases, it might be possible to do a cash-out refi while the house is still considered the primary residence, wait a year, then rent out the home, without having to refinance again at a higher investment-property rate.
Not every lender will go for that, says Bob Moulton, president of Americana Mortgage Group Inc. "At the time of application, you want to be as honest as possible with the loan officer in terms of exactly how the property will be used," Moulton says. "Different lenders have different criteria and some are restrictive or prohibitive of you renting the house out."
A cash-out refinance isn't the only way to extract equity to buy a second house. You also can use money from a home equity loan or equity line of credit. Rates on lines of credit usually are below rates on fixed-rate mortgages.
Moulton has clients who owe $225,000 on a house worth $1.5 million. They wanted to buy a condominium in the ski resort town of Park City, Utah. So they got a home equity line of credit, or HELOC, at a rate of less than 5 percent to buy and furnish the condo in Park City.
The downside, Moulton says, is that the rate on the line of credit is tied to the prime rate and can rise. But his clients probably can handle any increase.