7 Tips for Financing Your First Vacation Rental Property

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Advancements in pricing technology and record-high occupancy rates are delivering historic revenue for vacation rental owners across the country. If you are in the market for a vacation home, now is a great time to determine your buying power.

According to the 2018 National Association of Realtors (NAR) Investment and Vacation Home Buyers Survey, over 70 percent of vacation homeowners and investment property owners believe now is a good time to buy. But don’t start comparing cap rates just yet. Unless you plan to buy your home with cash, you will have to find a way to finance it.

Vacation properties and primary residences are financed differently, and the process has a reputation for being confusing. But in last year’s NAR survey, nearly 60 percent of respondents said financing their vacation home was either not difficult or less difficult than they expected. For many more buyers, choosing the best financing option for vacation properties is no more arduous than it was for their primary residences.

It’s true that banks will hold you to new standards and you will have to make some commitments about how the property will be used, but with the right knowledge, you can enter the buying process confidently. I wish you luck on the journey to buying your first vacation rental. Over half a million people buy vacation homes each year and more than three quarters of them finance the purchase, so you are in good company.

Here are some tips to help you along the way.

7 Tips for Financing Your First Vacation Property

1. Think like an underwriter.

The first step to securing financing for a vacation property is finding out if you’ll qualify. This means putting on your banker’s hat and taking an honest, critical look at your financial standing. Start by checking your credit score. Lenders want to see higher credit scores for vacation properties. For example, Fannie Mae sets it’s minimum FICO credit score at 640 for vacation homes with a 25 percent down payment. That’s 10 percent higher than its minimum credit score requirement for a primary residence with the same 25 percent down.

Related: These Markets Are Delivering The Best ROI on Vacation Rentals

The next thing you should think about is your cash reserves. Those are the funds you’ve saved to cover bills for both your vacation property and primary home should you lose your job. Lenders prefer to see six months of cash reserves, though they may be flexible for well-qualified wage earners.

2. Factor your debt-to-income ratio.

Debt-to-income ratio, more commonly referred to as DTI, is calculated by dividing total recurring monthly debt by gross monthly income. It takes into account everything from your taxes to your mortgage and car payments.

DTI is one of the most common tools mortgage lenders use to estimate your ability to pay them back. Factor your DTI before shopping for lenders. It will give you a sense of your potential leverage in negotiations or let you know that it’s not a good time to borrow. In vacation home financing, lenders commonly require a DTI of 43 percent or lower. And they will want to see proof of your financial stability, such as pay stubs, 1099s, and a couple of years’ worth of W2s.

3. Clarify your intentions.

When asking lenders to finance your vacation property, they will want to know how you plan to use it. You can generally secure a better mortgage interest rate with a conventional loan. Whether or not you get that will depend on factors such as how often you plan to use the property and how far away it is from your primary residence.

If you’re like most vacation home buyers, you will opt to put your property to work driving rental revenue. If you plan to rent it out full-time with little-to-no personal use, lenders will consider it an investment property. Mortgage rates options for investment properties are different than what you will see for private second homes.

Be honest. Both you and your lender should clearly understand how you will use the property—and the consequences of changing that usage later.

4. Save 20 percent (or more)

A great way to show lenders that you’re financially stable is by having cash on hand. While you might be able to secure a FHA loan with as low as a 3.5 percent down payment for a primary residence, investment property mortgages typically require a down payment of 20 percent or more.

In 2017, nearly half of all vacation home buyers paid down payments of 30 percent or more. Paying down more up front typically gets you better interest rates. If you pay over 20 percent in your down payment, you will be able to avoid private mortgage insurance (PMI) on your loan.

5. Harness home equity.

According to NAR, around one fifth of vacation home buyers tap primary home equity to help finance their down payment. It’s not a bad time to think about this option. TD Bank’s 2017 Spring Home Lending Survey found that nearly 70 percent of homeowners have seen their home equity hold strong or increase over the last 18 months.

Two common home equity options for buying a vacation home are home equity line of credit (HELOC) and cash-out refinancing. The basic difference between the two is that a cash-out refinance loan refinances your first mortgage into a larger mortgage while allowing you to take out the difference in cash, whereas HELOC is a line of credit backed by home equity.

There are pros and cons to both options. For example, with cash-out refinance you may be able to lock in a lower rate for your mortgage while still having just one payment. HELOC gives you a revolving line of credit against your equity, but you typically have to agree to a variable rate.

6. Borrow for the right usage.

How you plan to use your vacation property will influence your financing options. For example, if you’re buying exclusively for family use, you might secure better terms through a conventional loan. If you plan to operate it as a rental that you rarely visit, research investment property loans.

Related: 9 Ways to Update Your Vacation Rental for Millennial Travelers

If you apply for an investment property loan, the lender will ask to see a comparable rent schedule. Lenders factor your anticipated rental revenue and expenses into your DTI. If the property you’d like to buy is an established rental, it may already have reservations on the books. The previous homeowner’s property management company may be able to provide you with detailed rental revenue history plus future income projections.

Talk to a specialized lender if you’re thinking of renting out your home. Many lenders will want you to take out an investment loan. Others may be comfortable with allowing a conventional loan if you’re uncertain of your long-term plans. In either case, it’s important to be transparent from the start.

7. Buy with confidence.

You don’t have to be a millionaire to own a vacation home. According to NAR’s 2016-2017 Investment and Vacation Home Buyers Survey, only 35 percent of vacation home buyers had household incomes higher than $100,000. You probably have more buying power than you think. For example, many underwriters will take your 401k into account when factoring your net worth. And many 401k plans allow you to take out a loan to buy property. Be sure to check with your financial advisor first. Once you’ve wrapped your head around your loan options, you can start thinking about ways to maximize ROI.

As with finding a home contractor that can meet the needs of your ideas and budget, find a lender who can work with you on options that fit your current financial goals. For example, will they allow you to refinance your conventional loan into a HELOC to get some cash out for remodels that will increase the home’s rental ROI?

Owning your first vacation home is a life-changing experience that’s more within reach than most people think. Financing is available, and securing it is simply a matter of understanding your options so that you feel confident throughout the process—from shopping for lenders to closing.

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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.