Vacation home loans and alternative options

Whether you want a vacation home as a place to enjoy on your own or as a profitable real estate investment, making that purchase is a major milestone. It can also be a costly dream. Luckily, borrowers have a few options for financing a vacation rental, including conventional mortgages, home equity financing, and joint investing. 

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In this blog, we’ll discuss everything you need to know about financing a vacation home, including how to purchase one, financing requirements, and how to determine which financing option is best for you. 

How to purchase a vacation home

Buying a vacation rental is very similar to purchasing a first-time home. You’ll need to gather key documents, meet certain financial requirements, and choose a financing option. However, financing terms for vacation rentals differ slightly from terms for primary residences. 

Financing options

While conventional mortgages are a go-to for vacation home financing, it's crucial to note that certain government-backed loans are not eligible since a vacation property is treated as a second home. This includes Federal Housing Administration (FHA) loans and U.S. Department of Veterans Affairs (VA) loans. 

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If you plan on buying a vacation home with a mortgage loan, you’ll need to take out a conventional mortgage at a fixed or adjustable rate.

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Fixed-rate mortgages have an interest rate that remains constant throughout the loan term, normally lasting 15 to 30 years. Borrowers who prefer predictable monthly mortgage payments might choose a fixed-rate mortgage over an adjustable-rate mortgage. 

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The interest rate on an adjustable-rate mortgage fluctuates periodically. After an initial fixed-rate period of 1 to 10 years, the loan's interest rate can change, impacting your monthly payments. Homebuyers who want to take advantage of low interest rates and don’t mind fluctuating payments may prefer an adjustable-rate mortgage over a fixed-rate mortgage.

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Rates will vary depending on the lender, but loans for secondary residences are higher than primary residence loans.  

Vacation home loan requirements

Vacation home loan requirements are often more stringent—especially if you intend to rent the property or have other mortgage obligations. 

Credit score and payment history

Lenders prefer borrowers with good credit scores and a long history of on-time payments. Making consistent monthly payments on your existing debt and maintaining a FICO score of at least 620 increases your chances of approval. 

Debt-to-income ratio

You should also take note of your debt-to-income ratio (DTI), which measures how much of your monthly income goes to debt. Most lenders prefer a DTI of 45% or less when considering loan applications for vacation homes. If your DTI is at or above the threshold, consider paying down debt or increasing your income before applying for a vacation home loan. 

Income and employment 

Proving consistent income and stable employment is crucial to getting approved for a vacation home loan. If you have a traditional job, you will need to present recent pay stubs and two years' worth of W-2 forms. If self-employed, you'll have to show two years' worth of personal or business tax returns. Some mortgage lenders may ask for additional documentation, such as profit-and-loss statements or business balance sheets. 

Down payment

Like any mortgage loan, you’ll need to offer collateral in the form of a down payment. If the other financial factors mentioned above are all in good standing, you can expect to put down 10% of the purchase price. If areas of your financial health are not the best, such as a lower credit score or high DTI, expect lenders to ask for 15% to 20%. 

Alternative equity financing options for vacation homes

While conventional mortgages are a common source of funding, they aren’t the only way to buy a vacation home. 

Home equity financing

If you already own a house, you could leverage the equity in your home to finance a second property.

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To qualify for a home equity product, you’ll need to have enough equity in your home. Lenders typically require borrowers to own 20% or more equity. 

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There are several home equity financing products to choose from:

Home equity loan

A home equity loan is a lump sum of money borrowed against the equity in your home. The loan is usually repaid over a fixed term on a fixed interest rate.

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Pros:

• Predictable monthly payments: Borrowing on a fixed interest rate allows you to predict your monthly payments over the entirety of your loan term.
• Cash upfront: Receiving all of the funds in a lump sum may allow you to either purchase a vacation home outright or at least make a large down payment.
• Tax-deductible interest (in certain cases): If you use your home equity loan to improve or build your vacation home, the interest paid on the loan may be tax-deductible.

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Cons:

• Higher closing costs: When compared to HELOCs, home equity loan options often come with higher closing costs.
• Risk of foreclosure: If you are unable to pay the loan back, you could lose your primary residence.
• Stringent requirements: You’ll need excellent credit and lots of equity to qualify. 

Home equity line of credit (HELOC)

A home equity line of credit (HELOC) is a revolving line of credit secured by the equity in your home. Instead of receiving funds upfront, you borrow as you need, up to a certain credit limit throughout the draw period. HELOCs work similarly to credit cards, except the credit limits are higher. The interest rate on a HELOC is usually variable. 

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Pros:

• Flexibility: A line of credit allows you to borrow and repay funds as needed during the draw period. This helps you manage expenses as they arise and discourages overborrowing upfront.
• Lower closing costs: The cost of financing a HELOC is usually less than financing a home equity loan.
• Tax-deductible interest (in certain cases): Similar to home equity loans, the interest paid on a HELOC may be tax-deductible if the line of credit is used to improve or build a vacation home.

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Cons:

• Variable interest rates: If interest rates are high during the repayment period, you may end up paying more interest on your HELOC than you initially expected.
• Potential for foreclosure: Defaulting on a HELOC is equally as harmful as defaulting on a home equity loan, putting your primary residence at risk. 
• Stringent requirements: As with a home equity loan, lenders look to minimize risk with strict requirements for credit and income. 

Home Equity Investment 

A Home Equity Investment allows you to tap into your home equity for a lump sum of cash in exchange for a share of your home’s future appreciation. There are no monthly payments. Instead, you repay your investment when you refinance, sell the home, or use another source of cash anytime during a flexible 30-year term. 

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Credit score requirements start at 500, and there are no income requirements to qualify. 

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Pros:

• Immediate cash: Like other financing options, HEIs offer a lump sum that you can use for a large down payment or to buy the property outright. 
• No monthly payments: You can buy your vacation home without concern for restricting your monthly cash flow. 
• Flexible terms: You’ll have 30 years to repay, but you can repay at any time, penalty-free. 

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Cons:

• Balloon repayment: When it’s time to repay your investment, you’ll need to pay it in full. This can be challenging for homeowners who don’t have a buyback plan. 
• Unknown cost: Since you’ll be sharing a portion of your home’s future appreciation, you’ll only know the true cost when you decide to repay your investment. 
• Risk of foreclosure: Although uncommon, failing to repay your investment could result in foreclosure. 

Cash-out refinance

A cash-out refinance allows you to replace your mortgage with a new loan for a larger amount than what you currently owe. You pocket the difference as a lump sum payout. When refinancing, you’ll get a new mortgage rate and terms, so it’s crucial to consider the long-term costs incurred if you replace your current rate. 

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Pros:

• Single monthly payment: A cash-out refinance allows you to consolidate your existing mortgage and vacation home funds into a single loan, simplifying debt repayment.
• Cash upfront: Similar to a home equity loan, a cash-out refinance provides you with a lump sum of cash upfront, which you can use at your discretion. 
• Lower interest rates: If you refinance your mortgage when interest rates are low, you may be able to secure a lower rate, which could reduce your overall borrowing costs. 

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Cons:

• Higher closing costs: While you might end up saving on interest payments, you’ll have to pay closing costs similar to those of a home equity loan.
• Longer repayment term: You’ll likely be extending your mortgage terms. Also, depending on the rate at which you refinance, you may end up paying more interest over time.
• Risk of foreclosure: As with any mortgage, defaulting on a cash-out refinance can lead to foreclosure, putting your first home at risk.

Joint investing

If the vacation property is a real estate venture, explore joint investing. Joint investing, or co-investing, allows people to pool financial resources from multiple investors. Each investor contributes to a portion of the down payment, closing costs, and ongoing expenses. All investors share ownership of the property and split its rental income. They would also make decisions according to the terms outlined in their agreement, such as whether or not to hire a property manager.

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Investors can be someone you know, or you can leverage an online platform to connect with real estate investors. 

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Pros:

• Shared expenses: Joint investing lowers the barrier to entry for purchasing a vacation home by allowing investors to share upfront costs, maintenance expenses, and overall responsibilities.
• Diversification: Investing in a vacation home with a group of people instead of by yourself diversifies your real estate assets and reduces overall risk.

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Cons:

• Shared decision-making: Joint ventures require investors to make decisions together, creating opportunities for disagreements regarding guest preferences, property management, and whether or not the property is placed for sale.
• Risk of financial strain: If one investor decides to sell their share or encounters financial difficulty, the other investors will need to compensate. This can reduce the financial rewards and overall enjoyment of all investors.

Final thoughts: Determining what kind of vacation home financing is best for you

Conventional mortgages are one of the most common and independent ways of financing a vacation home. They’re best suited for borrowers with strong credit, stable income, and low-risk tolerance. 

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However, if you’re concerned about meeting qualifications, explore your options. Home equity products are viable financing options for homeowners interested in flexible borrowing terms. Joint investing can help budding investors diversify their portfolios and build a network.  

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There are plenty of ways to finance a vacation home. Your current finances, risk tolerance, and long-term goals will determine which method is best for you. 

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A Home Equity Investment from Point can help you buy the vacation home of your dreams with the added flexibility of no monthly payments. Explore Point’s HEIs here.

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