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New homes offer new possibilities and opportunities for a buyer. Still, these possibilities may be limited depending on how the lender categorizes your property. Knowing the key factors lenders use to differentiate between a second home vs. investment property can help you as well; it can help you determine whether you’ll need to apply for a primary residence mortgage or a second home or investment property mortgage. The loan terms outlined in each differ and may dictate how you’ll use your property.
Investment property is any property including building or/and land held to generate income or for capital appreciation or maybe for both. Investment properties are usually not owner-occupied and not used to supply or produce goods and services.
It is a property that you purchase added to your current residence to live in for part of the year. You don’t occupy the house full-time but whose primary purpose isn’t as a rental property. A Second Home is a home that’s not your primary residence, but you don’t use it as an investment property. Don’t be confused with ‘second home.’ There can be multiple properties treated as second homes.
There are criteria that differentiate an investment home from a second home. Those criteria are listed below:
The criteria lenders use are often derived from the IRS. However, the criteria are not necessarily the same in all aspects, so it is best to consult with an accountant for guidance.
For lenders, the second home or investment property carries a considerable amount of risk compared to the primary residence. From the lender’s point of view, the owner is more likely to pay the primary residence mortgage than your second home’s mortgage.
So, there will be higher second home mortgage rates and stricter second home mortgage requirements. You might not have paid a down payment when you bought your primary residence. However, you may be asked to do so when applying for a loan for your second home or investment property. You’ll also need to have a good credit score and sufficient cash reserves for closing costs.
You can get approved for a mortgage for a single-family second home only. When applying for a loan on investment property, you can get approved for a loan on up to 4 apartments.
For a similar-sized home and equal down payment, you may be asked to pay a higher interest rate for an investment property than the second home. This is usually because lenders believe there is a higher risk in lending money for properties.
Like the mortgage, the amount needed for a down payment is based on the borrower’s credit score. For a second home, the down payment required is typically 10%, while, with a second home or investment property, you may be asked to pay anywhere between 15% and 20%.
The minimum credit score you can have when applying for an investment property or second home loan is 640. The maximum debt-to-income ratio allowed is 37-45%; if your debt-to-income ratio is higher than 36%, you will need to have a minimum credit score of 680 to secure a loan for an investment property or 660 to be approved for a loan on a second home.
Having an investment property translates to future profit. As a result, the lender may also factor in potential future income when calculating your debt-to-income (DTI), but unfortunately, this perk is not considered if you’re buying a second home.
It’s possible that the lender may charge you more in origination fees for your investment property than for your second home because the bank considers you a higher risk.
Generally, second homes get treated as your first homes. As long as you are using it as a second home, you may write off taxes as you do on your primary residence. The same rule applies to mortgage interests. You can write off the interests of up to $1 million in mortgage debt on your second home that were taken to improve or buy the property.
On the contrary, investment properties don’t enjoy the same perks as second homes. Investment properties generate income and you have to report your income and expenses from your rental homes. Schedule E form is used for this purpose which allows you to deduct just about every expense that you incur in owning the property.
And, you have to pay taxes on the profit that you earn on the home after expenses. And if you incur losses, you can sue them to offset income from other investment real estate properties.
If the property that was initially bought as a second home is used as an investment property, you will need to notify the lenders and the IRS. You must be very clear about your intentions and possible reasons for changing the status. Otherwise, you may face tax penalties.
Mortgage lenders will check your tax filings to ensure that you are using the property as intended. They will also use the information listed on your credit reports. If they discover rental income during their review, you might be accused of occupancy fraud.
Interest rates and mortgage terms vary by lender. You may have to shop around to find the best interest rates for your investment property or your second home.
Every mortgage application will ask a question about how you intend to use the property you are purchasing. You will have to answer that question with one of the following: secondary home, primary residence, or investment property. Your mortgage rate will be calculated based on your answer. Similarly, your loan terms will be made accordingly.
Primary residences usually have a lower interest rate compared to the interest rates of the other types, primarily because the lender considers that the buyer will be more likely to consistently pay the mortgage for their primary house as opposed to the others.
The property that is purchased as your primary residence should have the following:
It is also important to note that, for buyers, proof of residency is required when refinancing your primary home mortgage.
Another essential thing to note is that your property cannot be listed as a primary and a secondary property at the same time. There are criteria that differentiate a primary residence from a secondary home. You shouldn’t be living in the secondary home for an extended time, whereas, with a primary residence, the expectation is that you’ll live there for most of the days of the year.
In addition, unlike with the primary residence, it is not necessary that the residence is close to your workplace. The perfect example of a second home is a vacation home where you are not asked to stay for the whole year but remain there for a short time. Moreover, this property is not included in your investment property but is considered your second home.
A few types of loans can not be used for buying a secondary home. Examples include FHA loans and VA loans. While evaluating a mortgage for a second home, other financial considerations are also considered. For example, lenders tend to be more strict about the borrower’s debt-to-income ratio and their credit score.
To get a tax deduction, the property should be considered a second home and should not be used as an investment property.
The criteria for considering a property as a second home are:
For example, if you have rented out your home for 200 days, you must stay at your home for at least 20 days. This will ensure that the house is your second home, as this is an essential criterion for classification as a second home. It is comparatively easy to meet these mortgage requirements compared to those of an investment property.
A secondary home cannot be considered a second home because there are different criteria for both homes.
Vacation homes are considered second homes, so the same mortgage rates may apply to vacation homes as that of second homes.
Depending on the purpose of the second home, it can work in your favor.
Yes, mortgage rates are likely to be higher for investment properties than those of primary residences or second homes.
Lenders typically charge higher interest rates on property purchased as an investment property because the property will be generating an income.
In addition, the lender may perceive that the risk is higher with investment properties since it’s not the borrower’s primary residence. With that in mind, there’s an increased risk that the borrower will walk away from the financial commitments of the second home.
Lenders also ask the borrower for a larger down payment (25%) when securing a loan for a second home or investment property than with a primary residence. So, we can conclude that the higher rates and higher down payment requirements are designed to give the lender reassurance that the borrower will pay off the loan.