Seconds, Anyone?
Making the most of your vacation home for the least
Kevin J. Daum

This article was originally published in the October 2005 edition of Log Homes Illustrated magazine.

Ah, the getaway cabin. That image comes to mind when most people think of building a log home as a second home. Having a second home is very appealing, for many reasons. One is the convenience of having a place you can escape to at a moments notice without having to make reservations or check availability. Some people are motivated by having an alternative life style. For those living in the city, the chance to escape to their own little piece of the country can be very enticing.

More and more baby boomers are capitalizing on their retirement wealth and the real estate boom to purchase or build second homes. The emotional benefits are obvious, but what about the distinct financial benefits of building and owning a second home? What about the financial pitfalls?

Appreciation. These days, real estate is appreciating rapidly, and many people are looking for ways to justify buying more property. Not all areas appreciate consistently, but resort areas within a reasonable distance of major cities tend to do well. Like most real estate, a second home should be evaluated as a long term investment. Over a five to ten year period it is not unreasonable to expect 3 to 5 percent annual appreciation. By leveraging the property with a low down payment this can make for a valuable investment that gives you added enjoyable benefits.

Financing. While financing a second home doesn’t have to be a nightmare, there are variations on the guidelines associated with second-home financing. As usual lenders have their own definitions and rules when it comes to second homes.

Lenders will look for you to manage a second home like any other debt such as a car and credit card payments. Most lenders will look for your total debts, including both houses, to be no more than 40 to 45 percent of your total gross monthly income. If you stretched to buy your primary residence you may have some challenges meeting the criteria.

Most lenders offer No Income Verification (NIV) loans programs for second homes so those of you willing to stretch further can still find ways as long as your credit is strong. Some lenders will charge a premium on their rates and fees for second homes and may require a stronger down payment, although there are some aggressive lenders offering 100 percent financing with NIV at higher rates.

Unlike loans for a primary residence, lenders are perfectly comfortable with multiple partners buying a second home together. Lenders like common occurrences and recognize that friends go in on retreat homes all the time. Remember that the lender will require and evaluate complete information from each and every partner taking title to the property. Ultimately, the lender will calculate all of the combined income and debt and look for the previously discussed debt-to-income ratio. Make sure you discuss all aspects of credit and finances with your partners since the lender will make their decision based upon the weakest credit of all the partners.

When considering a partner for your second home you should decide up front who will supply what cash for the project, and discuss methods and timing for selling the property and dividing equity. Remember you are entering a business transaction with significant value, and everyone has unique emotional issues related to money and real estate. It is best to err on the side of over-communication.

Often, people buy second homes with the intention of making it a vacation rental in order to defer costs. In many resort areas, the real estate agents handle vacation rentals as well as home sales. Beach houses and lake houses often rent out by the week or for weekends on a seasonal basis leaving plenty of time for the owner to enjoy it in the off season or on weekdays.

If you represent rental income to a lender on a second home, the lender must treat the home as an investment property rather than a second home. This can make a major difference in the cost of your loan, as well as the size of the down payment. If you are planning to rent the property, it is best to wait to make this decision until the financing is done so you can represent your finances to the lender in a honest and forthright manner.

Lenders are always on the lookout for people trying to buy rental properties disguised as a second home. The lender will evaluate your second home within the context of where you currently live, as well as the surrounding location. Lenders look for explanations that make sense, so if your second home is in a suburban neighborhood a few blocks away or even in the same general city area they, are likely to be suspicious. Most lenders are perfectly comfortable with houses in rural and resort areas that you can travel to reasonably.

Tax issues. As usual, the Internal Revenue Service has their own rules when it comes to second homes. Home interest is tax deductible and the interest on your mortgage on a second home is no exception. As long as the combined loans between the two homes do not exceed $1,100,000 you may be able to write off the interest on your tax returns. Of course, there are other criteria, such as the size of your original loans and the amount of improvements made to the homes. Not only is the interest deductible but so are the points paid on mortgages. With no limit on the size of loans, it can be to your advantage to buy down the rate on your mortgage. You can also take advantage of deducting the property taxes with no limitation.

If you are planning on renting the property as a vacation rental, that rent will be taxable and will classify the property as an investment property, affecting your deductibility status. It’s best to check with your CPA to assess all of the tax-saving opportunities and issues.

Cash flow. The main step to deciding if a second home is right for you is analyzing whether or not you can truly afford it. Remember that just because a lender says you can qualify doesn’t mean you can manage all the expenses every month.

First, you need to evaluate all of the costs involved. You’ll need lots of cash for the down payment and closing costs, as well as running the construction project if you are building. Once you have acquired the home, you will need to furnish and decorate it. This, of course, is no different from buying a new house and moving in as a primary residence.

But here’s the unexpected part. Usually when you move from an existing residence you have all the basics such as clothes, TV, bathroom items and pots and pans. This new home will be like starting from scratch. You may be able to take some of the extra items you may have around your home, but chances are you will need to be making plenty of trips to Wal-Mart, Circuit City and Bed, Bath & Beyond. Clothes are another expense to be incurred since avoiding loading up the car was one of the motivators for having a second home in the first place. Make a list of items you already have that you can take to your getaway and make a list and budget for everything else.

Now that you have figured the amount you will need from your savings, consider the payment. Along with the payments on your mortgage, you will need to include the cost of the property taxes as well as the hazard insurance. If your second home is in a planned development with common amenities, you may also have a homeowner’s fee to pay. Don’t forget to budget in an amount for maintenance or at the very least a home warranty.

Once you have an estimate of the monthly payments, you will want to assess the net payment after tax deductions that were addressed previously. Now is the time to figure out if owning a second home is worth it to you. Here is a formula to work with. Assess the cost of your cash invested by multiplying by 3 percent, which is similar to what you would get in certificates of deposit. Add that to 12 months of your net monthly payments after tax savings. Subtract any rents you receive, along with a reasonable expectation for appreciation, such as 3 percent of the value of the property. Take the final total and compare this amount you will pay annually for this house with the amount you normally spend each year on vacations.

Some people find that having a second home makes them feel obligated to use it often enough to get their money’s worth. Take the time to evaluate your lifestyle and vacation desires. If having a second home robs you of your longtime desires to travel the world, then consider partnering or renting someone else’s second home. But if your own private hideaway is sufficient motivation to stretch financially, who can blame you? Ultimately there can be a certain emotional satisfaction to having your own private getaway that can’t be quantified in monetary terms.

About the Author...
Kevin Daum is the Founder and CEO of Stratford Financial Services, a Real Estate finance and education company, founded in 1989. Stratford specializes in Purchase loans, Refinance loans and Custom Home Construction finance and has successfully financed thousands of clients. He is the author of "Building Your Own Home for Dummies" (Wiley), as well as "What the Banks Won’t Tell You." Mr. Daum was an Underwriter for Plaza Savings and Loan and Key Bank of New York. He is an INC 500 CEO and has been listed as one the 40 Most Influential People Under 40 in the San Francisco Bay Area. He is the Global Chair for the Edison Innovation Program with the Young Entrepreneurs' Organization (YEO) and is a founding Board member of the Bay Area Chapter of YEO.

Mr. Daum is a frequent contributor to numerous business publications on the subjects of Real Estate and Small Business leadership and speaks regularly on both subjects. He can be contacted at kevin@stratfordfinancial.com.