Josephine Norton
When applying for a mortgage, you will be asked how you plan to use the property – as a primary residence, secondary residence, or investment property. This is because the type of residence you choose will impact the mortgage rates available and the requirements needed to be approved for a home loan. For example, primary residences are considered lower risk and are therefore offered the lowest interest rates. In contrast, secondary residences are considered riskier and have higher interest rates and tougher qualification requirements.
How does a secondary residence impact a mortgage?
| Characteristics | Values |
|---|---|
| Interest rates | Higher than primary residences |
| Down payment | Minimum of 15% to 20% |
| Qualification requirements | Tougher than primary residences |
| Risk | Higher for lenders |
| Location | Shouldn't be too close to the primary residence |
| Tax benefits | No tax breaks for mortgage interest paid |
| Rental income | Cannot be used to offset expenses |
| Debt-to-income ratio | Lenders count primary and secondary home expenses |
What You'll Learn
Higher interest rates
When applying for a mortgage, you'll be asked how you plan to use the property – as a primary residence, secondary residence, or investment property. This categorisation will impact the mortgage rates available and the requirements needed to be approved for a home loan.
Lenders must assess the level of risk in providing you with a mortgage, which means determining how likely you are to pay back your loan. The riskier the loan situation, the higher the rates and the stricter the requirements for approval. Lenders view primary residences as lower risk because homeowners are more likely to stay on top of payments for the roof over their heads. As a result, primary residences often qualify for lower mortgage rates.
Second homes are viewed as riskier than primary residences because borrowers may prioritise payments on their primary residence in the event of financial difficulties. This means that second home mortgages often have higher interest rates and tougher qualification requirements. To qualify for a second home mortgage, you may need to meet higher credit score standards, have a down payment of at least 20%, and meet specific cash reserve requirements. Cash reserve requirements mean you must have enough money in liquid savings to cover the mortgage for a few months if necessary.
The IRS views second homes as investments. Unless you've lived in your second home for an extended period, you'll pay long-term capital gains of up to 20% of the property's value when you sell it. In contrast, selling your primary residence allows for capital gains exclusions of up to $500,000 if filing jointly with a spouse.
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Tougher qualification requirements
When applying for a mortgage, you will be asked how you plan to use the property – as a primary residence, secondary residence, or investment property. This categorisation is important as it will affect the mortgage rates available to you and the requirements you need to meet to be approved for a loan.
Lenders must assess the level of risk when providing a mortgage, which means they will determine how likely it is that you will pay back your loan. The riskier the loan situation, the higher the rates and the more stringent the requirements for approval. Lenders view primary residences as lower risk because homeowners are more likely to stay on top of payments for the roof over their heads.
Second homes are a different story. Lenders view these properties as investments and therefore riskier propositions. Because you’re not dependent on your second home for a place to live, lenders assume that you may be more likely to stop making payments on the loan if you fall on hard times. As a result, second home mortgages can come with tougher qualification requirements, higher interest rates, and higher down payment requirements.
To qualify for a second home mortgage, you may need to meet higher credit score standards, have a down payment of at least 20%, and meet specific cash reserve requirements. Cash reserve requirements mean you must have enough money in liquid savings to cover the mortgage for a few months if need be. Lenders will also count your primary and second home expenses when calculating your debt-to-income ratio (DTI). This means that you may need to meet higher income requirements to qualify for a second home mortgage.
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Higher down payments
When applying for a mortgage, you will be asked how you plan to use the property—as a primary residence, secondary residence, or investment property. This categorisation will affect the mortgage rates available and the requirements for approval. Lenders must assess the level of risk in providing a mortgage, which means determining how likely it is that you will pay back your loan. The riskier the loan, the higher the rates and the stricter the requirements for approval.
Lenders view owner-occupied properties as lower risk. Loans for primary residences come with lower interest rates and down payment requirements compared to secondary residences and investment properties. This is because homeowners are more likely to stay on top of payments for their primary residence. If you default on your primary home mortgage, the consequence of not paying would be most severe as you could become homeless.
A secondary residence is a property you use for recreational or vacation purposes. Although you live there part-time, it isn't your primary residence. Lenders view secondary residences as potentially riskier than primary residences because borrowers may prioritise payments on their primary residences in case of financial difficulties. Because you are not dependent on your secondary residence for a place to live, lenders assume that you may be more likely to stop making payments on the loan if you fall on hard times.
The financial requirements for a secondary residence down payment are generally stricter than those for a primary residence. The minimum down payment for a secondary residence is typically at least 10% and sometimes up to 30%, depending on the lender and the borrower’s creditworthiness. Most lenders prefer a down payment of 20% or more. A down payment of 25% or higher can make it easier to qualify for a conventional loan. If you have a lower credit score or higher debt-to-income ratio, your mortgage lender may require at least a 20% down payment for a secondary residence.
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Tax implications
The classification of a property as a primary residence, secondary residence, or investment property has significant implications for taxes and mortgage interest rates.
For primary residences, homeowners may qualify for lower mortgage rates and income tax benefits. This includes the deduction of mortgage interest paid and the exclusion of profits from capital gains tax when selling the property. Taxpayers can currently exclude up to $500,000 in capital gains if married filing jointly or $250,000 if single.
The tax implications for secondary residences can be complex and depend on factors such as the usage of the property, the number of days it is rented out, and the timing of the acquisition.
If a secondary residence is considered a personal residence, mortgage interest may be deductible, provided it meets the same requirements as the primary residence. The total amount that can be treated as home acquisition debt for the main and second home depends on the timing of the acquisition. For homes acquired on or before December 15, 2017, the limit is $1,000,000, or $500,000 if married and filing separately. For homes acquired after this date, the limit is $750,000, or $375,000 if married and filing separately.
If the secondary residence is rented out for more than 14 days or 10% of the days it is rented (whichever is greater), it is considered a rental property, and the tax implications change. In this case, rental income must be reported, and expenses must be allocated between personal and rental use. While certain expenses, such as advertising or cleaning costs, cannot be deducted, other costs like mortgage interest, property taxes, insurance premiums, utilities, and depreciation may be deductible.
When selling a secondary residence, capital gains tax must generally be paid on the entire profit unless the property is made into a primary residence by living in it for at least two of the five years before the sale. This can be a complex calculation, and other exclusions, exemptions, or deferral mechanisms may apply, so consulting a financial or tax advisor is recommended.
Additionally, for those who plan to pass down a secondary residence as a family legacy, it is important to consider potential estate tax implications. Transferring ownership of the property to a qualified personal residence trust (QPRT) can help mitigate future estate taxes, although it is counted as a gift for federal gift tax purposes.
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Rental income
When it comes to a primary residence, rental income can be factored into your gross monthly income calculation. This is especially relevant if you plan to rent out a portion of your primary residence, such as a unit within a multi-unit structure. Lenders will typically require documentation of your rental income, such as tax returns or lease agreements, to establish a history of property management experience. They may also consider the potential rental income of your primary residence if you intend to convert it into a rental property. In this case, you should be prepared to provide details about the property's maintenance, management fees, taxes, and insurance.
For a secondary residence or investment property, lenders may consider the potential rental income to a certain extent. They usually take into account a percentage of the projected rental income, typically around 75%, to account for possible vacancies or maintenance costs. It's important to note that lenders may have stricter financial requirements for a second property since they consider it a higher risk. They will assess your ability to manage two sets of mortgage payments and may require proof of significant savings to cover additional costs.
The mortgage application process can vary based on the type of rental income and the property you are purchasing. It is recommended to consult with a mortgage advisor to explore your options and calculate how much you can afford. They can guide you through different mortgage types, such as traditional mortgages, VA loans, and DSCR loans, and help you develop income projections based on fair market value.
Overall, when considering a secondary residence, it is important to be prepared for a potentially more challenging approval process. Lenders will assess your financial situation, including your income, savings, credit score, and ability to manage multiple obligations. By providing comprehensive documentation and demonstrating financial stability, you can improve your chances of securing a mortgage for your secondary residence.
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Frequently asked questions
A primary residence is where you live and spend most of your time. A secondary residence is a property you use for recreational or vacation purposes.
Lenders view secondary residences as riskier than primary residences because borrowers may prioritize payments on their primary residences in the event of financial difficulties. As a result, secondary residences have higher interest rates and tougher qualification requirements.
The IRS views secondary residences as investments. Unless you've lived in your secondary residence for an extended period before selling it, you'll pay long-term capital gains of up to 20% of the property's value.
Yes, it is possible to change a property's occupancy status if you meet all the requirements of a primary residence. For example, a retired couple might decide to sell their primary residence and move into their secondary residence.
