If you are looking to acquire a new property for your real estate portfolio you may find yourself comparing mortgage rates for a second home versus an investment property. The difference between the two may seem like semantics, but they each have specific requirements that must be met to qualify.
If you are pursuing purchasing a second home you have to really think about what you want to get out of that property. Will it serve as a vacation home you will occupy occasionally? Do you want to use it entirely as an investment property? Will you use it when you have to travel for work? Your intentions play a big role in deciding if you should take out a mortgage on a second home or an investment property.
Many real estate investors looking to buy another property would opt to take out a second home mortgage because they are the most similar to a regular mortgage with lower interest rates and down payment requirements. But if you don’t intend to live on the property at all you could be setting yourself up for some trouble with the lender, IRS, and FBI.
So what is the difference between a second home and an investment property and why does following the rules matter?
A Second Home
A second home is a property that you own that you occupy for a specific number of days every year. A second home is something like a vacation home that you may visit every summer for a month or two or a property in a city that you use when you travel there for work. A second home, by definition, is a single-unit property that you own and reside in aside from your primary residence.
Depending on your lender there are usually occupancy requirements when it comes to getting a mortgage for a second home. According to the IRS, a second home is a property in which you reside for more than two weeks per year, or 10% of the time you rent it out to others. These occupancy rules purposely make it difficult for an investor to get a second home mortgage and then rent it out on a long-term basis.
An Investment Property
An investment property is a property that is purchased solely as an investment with no intention of occupancy by you. An investment property has no occupancy requirements and must be purchased with cash or with a mortgage specifically for investment properties.
Unlike second homes an investment property can be a multi-unit building, can be rented out short or long term, or can be flipped and sold.
Differences in Financing
If you are an investor looking to purchase a second property as an investment it may be tempting to take out a second home mortgage instead of an investment property loan because the rates and requirements are generally lower. But doing that could but you in a precarious legal position that could result in massive fines and an FBI investigation.
Second Home Mortgage
Second home mortgages tend to be similar to those of primary residences, with the same market rates, income, and credit requirements. The specifications may vary depending on the lender you are working with but you may see slightly higher credit and income requirements while you shop because there is inherently more risk in lending for a second property. Depending on the lender you also may see a slightly higher interest rate become of the inherent risk of a second mortgage. But usually the downpayment requirements remain the same.
Getting a mortgage for a second property is usually much easier than securing financing for an investment property. Investors that may not meet the income or credit requirements may try to cut corners and take out a second home mortgage instead.
Investment Property Mortgages
To qualify for an investment property mortgage you must meet higher requirements than a traditional mortgage. For the most part, your credit score needs to be over 720 and you need to be able to make a hefty down payment of around 15-25%.
Lenders generally put more strict parameters on an investment property because the risk of default is greater. If an investor hits financial trouble they are much more likely to continue making payments on the property they are occupying rather than an investment.
In addition to higher qualifications, investment property loans almost always come with higher interest rates. This is why it is so tempting for investors to try and take out a second home mortgage on an additional property, especially if it is their only additional property.
Don’t Cut Corners
If you have no intention of ever living in your second home you cannot apply for a second home mortgage, no matter how much better the loan terms look. While no one will knock on the door every day to see who is at home, lenders usually have pretty strict rules when it comes to lending for a second home. You will most likely sign something called an “occupancy affidavit” with the lender that spells out the rules of the loan and allows them to foreclose on the property if you violate them. This violation can not only cost you a lot of cash but can be damaging to your credit and the future of your business.
If you violate occupancy rules you could face legal action from the lender as well as the IRS. This is called “occupancy fraud” and could lead to huge fines and an FBI investigation – neither of which is good for a budding real estate investment business.
For the most part, you are allowed to make rental income on a second home as long as you are meeting the occupancy requirements set by the IRS and the lender. Some lenders are more relaxed and allow you to rent out the property for a period of time while others strictly forbid it. Before you take out any loan make sure you are working with a lender that offers terms that meet your needs.
As far as the IRS is concerned, if you rent out your vacation home 150 days out of the year just make sure that you occupy the property for 15 days (10%) to meet all of the requirements. To ensure you are not investigated you have to make sure that you report any rental income of more than 15 days.
While shopping for mortgages keep the requirements in mind to make sure you make a decision that benefits your business and keeps you out of trouble. Maintaining a good relationship with lenders and the IRS is important if you want to keep growing your business.