A Guide for Getting Started

Vacation rental homes are spiking in popularity and for good reason. A 2016 HomeAway survey showed that 70% of vacation rental homeowners could pay at least half the mortgage on their vacation home from the rental income it generates. For owners who work with professional property managers, the cashflow benefits may be even greater.

Investing in a vacation home that’s also a vacation rental can create a best-of-both-worlds scenario: You get to enjoy downtime in one of your favorite locations while getting an income-generating property that helps pay for itself. Full-service vacation rental management companies like Northern Michigan Escapes make life even easier by booking and communicating with guests while also managing the day-to-day responsibilities of the property.

The National Association of Realtors’ 2017 Investment & Vacation Home Buyer’s Survey revealed that 72% of vacation home buyers and 64% of investment property buyers used some sort of financing to fund their second home purchase. Financing a vacation home requires a slightly different approach than financing a primary residence, and working with a lender who specializes in second homes can be greatly beneficial.

There are a few vacation home financing options available that can make your dream a practical reality. 

Lending options

Home Equity Line of Credit (HELOC)

For the average homeowner, opening a HELOC on your primary residence maybe your best option for financing a vacation home. What is a HELOC? Simply put, it’s a loan based on the current equity within a home. Some homeowners can access up to 90% of their current home’s value when they choose to open a HELOC.

How does using a HELOC to buy investment property work? Depending on the amount of equity available from your primary home, you may be able to draw on a line of credit to pay for the second home. If the dollar amount doesn’t equal the full cost of the new home, the line of credit can be used for a down payment.

Taking out a HELOC means you won’t have to refinance the mortgage on your current home. The new loan isn’t attached to and doesn’t affect, the first mortgage in any way, but your interest rate will vary depending on the type of HELOC you choose. With lenders offering new options for HELOCs nearly every day, this type of loan could be a successful path to buying a vacation home.

Cash-Out Refinance for Primary Residence

Refinancing your primary home and cashing out on the equity might also be worth exploring. What is a cash-out refinance? It’s where you convert some of your home equity into cash, establishing a new mortgage for your primary residence. In some cases, you can use a conventional loan to borrow up to 80% of the value of your current home.*

Your new primary mortgage will depend on your credit score and your debt-to-income ratio, so make sure to discuss your refinancing options with a specialized lender. Don’t forget to do the math. If your primary home’s mortgage payment does increase significantly, you want to be sure you can afford the new second home payment, along with any additional fees, taxes, insurance, and more on both homes.

Investment Property Loan

An investment property loan is for homes that are intended to be income-generating properties. Typically, interest rates on investment loans are half a point higher than those on conventional loans. A good credit score (usually above 650) is needed and will help with the overall terms of the loan. Typically, you’ll need to put 20% down, but some lenders will let you start with as little as 15% down. (You’ll pay for the privilege.)

A low debt-to-income (DTI)** ratio is also important. Most lenders will require your total debt (including both primary and secondary home mortgages) to be at 45% of your monthly income or lower. Note: If you’re buying an investment property for short-term rentals, the future rental income will most likely not count toward your gross income for that calculation.

Finally, have some cash on hand. A good rule of thumb is to have enough cash to cover two to six months of rent on both your primary and secondary residences just in case you lose your job. If you’re risk-averse, more is better.

Conventional loan

A final option to consider financing a vacation home is a conventional loan. This is a tempting option, as conventional loans generally have lower interest rates than investment loans. What is a conventional loan? It’s a loan that falls under the Fannie Mae and Freddie Mac guidelines and has a fixed or variable rate with a set term. In most cases, your second home must be 50 or more miles away from your primary residence—otherwise, it will be classified as an investment property and is not eligible for financing through a conventional loan.

You can put as little as 10% down on a second home, but you will need to have a minimum credit score of 680. When considering a conventional loan, it’s worth comparing both adjustable-rate mortgages (ARMs) and fixed-rate mortgages. Zillow has published good data making the case that the default loan, the 30-year fixed-rate, doesn’t always net the best long-term return for the investor.

Be sure to talk to a specialized lender if you’re thinking of renting out your home. Many lenders will want you to take out an investment loan. Others may be comfortable with allowing a conventional loan if you’re uncertain of your long-term plans. In either case, we recommend transparency from the start.

 Next steps

Talk to a professional who is knowledgeable about vacation rentals and can provide you with helpful tools to make data-driven decisions. Find a lender offering the loan you want. Work with the loan officer to explore your options. Make sure you get the full picture of the costs for any financing—a rate and payment based on your situation. 

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