Owning a vacation home rental, whether it is an Airbnb rental property or another type of short-term rental, can be a very lucrative investment for any real estate investor. Thanks to new integrated software and apps, the vacation rental industry has continued to grow at an exponential rate in recent years. According to recent industry statistics, there are almost 300 million vacation rental users worldwide, with the revenue of vacation rental properties expected to hit $60 billion+ in 2020.
So, what are the benefits of buying a vacation rental property?
- Generate rental income – Buying a second home to rent out allows you to earn a steady passive income. The rental income will help you pay the mortgage and other costs such as renovation, insurance, maintenance, and property taxes
- Build value through appreciation – Real estate usually appreciates in value in the long run. This means that when you decide to sell your second home, you can sell it at a higher price and thus make a profit. You can even earn more money by making improvements and modifications to boost the market value of the home
- Earn tax deductions – Just like any other investment property, a vacation rental investment also allows you to enjoy tax deductions. These deductions apply to rental income, utilities, insurance premium, property tax, mortgage payments, and other rental expenses
- Take on less risk – By choosing an investment property and a location that works for either a short-term or traditional rental, you can lower your risk level significantly. If you find yourself having a low rental income, negative cash flow, and low vacation rental occupancy rates, you can switch the property from a vacation rental to a long-term rental.
- Easy to manage – Real estate investors can hire vacation rental management services or property managers to handle the day-to-day running of their properties. This frees up their time to handle more important aspects of vacation rental management or they can sit back and earn passive income
- Own a dual-purpose home – Besides renting out a vacation rental to guests, you can also use it as a second home whenever you travel for vacations with your friends or family. This allows you to save on accommodation expenses
Related: Pros and Cons of Owning Vacation Rental Property
All of those benefits sound great, right? And now you’re wondering “What’s the catch?” Well, one major challenge that real estate investors face is financing a vacation home rental property. They either don’t have the money saved up to pay in cash or just aren’t sure what financing options they have or what to do to get a mortgage. That’s why we’ve put together this guide.
So, are you considering buying your first vacation rental property this year? Here are some of the best ways to get investment property financing for a vacation home:
1. Cash-Out Refinance
As mentioned, real estate generally appreciates over time. A property owner that has built significant equity in their primary residence can take advantage of a cash-out refinance for financing a vacation home. For instance, a homeowner owes $100,000 on his mortgage, but his property is currently valued at $200,000 due to appreciation. He could tap into the equity by refinancing a larger mortgage and taking the difference in cash.
In this situation, the borrower will be able to pay a substantial vacation home down payment:
- New loan amount: $160,000
- Current mortgage: $100,000
- Closing costs: $3,000
- Available cash: $57,000
If you have good credit, you could borrow up to 80% of your property’s value with a conforming loan. VA cash-out vacation home loans allow veterans to access 100% of their equity, while FHA loans allow 85% cash-out refinancing.
2. Home Equity Lines of Credit (HELOC)
If you have sufficient equity in your current home, you can take a line of credit and use the money to pay for the down payment or buy the vacation home outright. This means that you will not have to refinance your current mortgage when financing a vacation home. Your first mortgage will remain as is while you add a new mortgage with different terms. In some cases, property owners can even tap into 100% of their property’s value with a home equity line of credit. Borrowers can choose between a home equity line with fixed second home mortgage rates or one with variable rates. The former comes with a higher rate, but better stability.
3. Conventional Vacation Rental Financing
You can get financing for a vacation home by applying for a conventional second mortgage from credit unions and banks. This is the same process involved in purchasing a primary residence. You will be required to pay an upfront down payment, followed by a payment plan spanning 15-30 years. Such investment loans come with either adjustable or fixed interest rates.
Related: Buying a Vacation Rental Property in 2020: Is It a Good Idea?
4. Reverse Mortgage
If you are aged 62 or older, you could use a reverse mortgage for financing real estate investments. These government-sponsored vacation home loans allow investors to borrow money from their primary residence without requiring repayment until they sell or leave the home. This allows older investors to own a second home while preserving their savings. However, please note that the interests will continue to accrue if the loan for financing a vacation home remains unpaid.
5. 401(k) Loan
Unlike other options for financing a vacation home, 401(k) vacation home loans don’t involve mortgage lenders. Instead, they allow you to access a percentage of your own retirement plan money on a tax-free basis. You will then be required to repay the money you have borrowed according to the designated rules. Requesting a 401(k) loan is easy and fast, requiring no lengthy credit checks or applications. The repayment plan is flexible and the costs involved are much lower compared to other vacation home loans.
Getting Approved for Financing a Vacation Home
Compared to loans for primary residences, second home mortgages are harder to acquire. The requirements for financing a vacation home will impact the interest rate, timeframe, and even the approval of the loan. If you are not careful, the process of financing a vacation home can wear down your patience.
Related: How to Get a Mortgage for Investment Property
To enhance your chances of getting approved for a vacation rental property mortgage, here are some things you need to consider:
- Strong credit score – When it comes to financing a vacation home, a strong credit score is very important for approval. Most lenders require a minimum credit score of at least 720. Borrowers with such a high score have a good amount of available balance and are therefore not likely to default on the mortgage payment
- Low debt to income (DTI) ratio – This is a ratio that compares an individual’s monthly gross income and their debt payment. DTI = Total monthly debt payments/Gross monthly income. Most lenders require this number to be below 45% before financing a vacation home. If you have a high debt to income ratio, forget about getting approved for the rental property mortgage
- Higher down payment – For primary home loans, the down payment required is usually 15-25%. However, the down payment is 20-30% for vacation rentals. In addition, some lenders will want these funds to be liquid in an account for at least two months
- Reserve funds – Paying a 20-30% down payment might not be sufficient. Many lenders expect borrowers to have extra money in reserves before financing a vacation home. For vacation rentals, you are required to have enough reserve funds to cover monthly payments for six months to a year
- Higher interest rates – Most lenders consider short-term rentals a higher risk than owner-occupied homes. As a result, the interest rate for vacation rentals is usually much higher. This will have a direct impact on your cash flow and make getting approved for financing a vacation home very difficult.
- A profitable vacation home: Because you plan on renting out the vacation home, lenders will want to see that they are financing a profitable vacation home that will make money. To find the best vacation rentals that even the most strict lender cannot refuse, click here.
Related: How to Find the Best Vacation Rentals for Sale
Buying a vacation home can be a great addition to your retirement plan or real estate portfolio. However, take time to weigh the pros and cons before jumping in. When thinking of how to finance a vacation home or how to buy a vacation home with no money down, compare all the financing options and choose one that works for your situation.