Can you afford a vacation home?

Purchasing a vacation property is a big decision that can come with big expenses. Once you’ve decided why you should buy a vacation home, the next step is nailing down the cost and determining whether you can afford it.

Vacation home financing is different from financing your primary residence. Mortgage lenders and the IRS will treat your purchase differently depending on how they categorize it—as a second home or an investment property.

Here’s what to know before jumping in.

What’s the difference between a second home and an investment property?

To categorize your home, the IRS will look at different factors (and may even define them differently). In general: An investment property yields rental income—whether from tenants or short-term guests—while a second home is for your own personal use. It may be easier to take out a mortgage for a second home than an investment property, but there could be tax trade-offs.

This tends to get complicated, so we’ll break down the major points. (Be sure to consult with a licensed financial advisor or accountant on your specific situation before moving forward.)

Vacation home mortgages

Unless you’re intending to buy your vacation home with cash, you’ll need a mortgage. Lenders are generally more fastidious when approving a second home mortgage. They tend to consider them secondary to your primary home mortgage—meaning you’ll have to pay the first one back before the second if you default on both loans and go into foreclosure.

Keep in mind that both rental properties and second homes are ineligible for government loans, like an FHA, USDA, and VA loans.

To qualify for a second mortgage, you’ll need:

• A debt-to-income ratio (DTI) below 41%: This percentage is determined by dividing your monthly debt by your gross monthly income. It essentially tells mortgage lenders how much of a financial safety net you have, and if you’d be able to still pay off your loans in the case of unforeseen circumstances.
• A good credit score: Maintaining a healthy credit score is always a good idea, but it’s especially important when buying a vacation home. The higher your score—a 620 or above is considered pretty good—the more likely you’ll be to qualify for a conventional home loan (and pay lower interest rates).
• Cash reserves: Lenders may look at how much money you have tucked away. Buyers with a savings account, a growing IRA, an emergency fund, and a college fund appear safer than a borrower with little money to their name.

Mortgages for investment properties

Investment properties usually require more stringent qualifications, higher down payments, and higher interest rates than second homes. This is because investment properties are considered higher-risk—if you run into financial trouble, you’re more likely to walk away from a home you don’t live in than one you do.

Mortgages for second homes

Second homes usually receive better mortgage interest rates and require lower down payments than investment properties.

Lenders typically require that a second home be at least 50 miles away from your primary residence, while an investment property is less than 50 miles away—because you aren’t likely to vacation in a home so close to where you live full-time. Being dishonest about your intentions is considered occupancy fraud.

Understand your mortgage loan options for buying a vacation home.