Before you write any contracts to purchase vacation properties, you need to obtain your financing. This will set you up for success in negotiations and give you leverage over other buyers! These 5 financing tips will help.
Obtain a pre-approval letter for up to a certain amount of money before you go look at properties.
- The pre-approval letter gives you leverage when you begin to write offers. Remember that the less you put down, the better cash-on-cash return you’ll receive, though your payment will be higher. For the best rates, most lenders require you to put 20% down. They don’t want to loan more than an 80% loan to value on a particular property. However, some lenders will loan 90%.
- A pre-approval letter is the closest thing you can carry to cash. I like to have already obtained a pre-approval letter when I start looking, because if I want to make a lower offer on a property, then the seller can see that I’m a strong buyer. This enables me to make a stronger value play. It doesn’t always mean they’ll accept, but it works well.
- A pre-approval letter takes a while to get because a processor has to verify all of the facts with the loan officer on your loan application. Then they submit it to an underwriter and if any flags come up they have to start over. This can make it worth it to start early.
When applying, classify the property as a second home, not an investment property.
- A second home gets you better terms on your loan. The terms on a second loan for a mortgage lender are about as good as they are on your primary residence.
Know your credit score. I would find this out before ever making a loan application.
- When looking at a vacation property, you want your credit score to be 660 and up. Every 20 points up, the better you are—and anything from 720 and beyond gives you the best opportunities for a good loan and a good interest rate. You can buy property with a lower score than 660, but you won’t get great terms.
- Make sure to purchase your credit score from the credit bureaus (Experian, Equifax, TransUnion). Most of the time, the freebies online don’t actually give you the number of your credit score. And those that do are not often accurate. So I would go ahead and purchase it from the three credit bureaus. It doesn’t hit your credit when you purchase it yourself either.
Have seasoned funds (for 60 days). Have the funds in an account in your name—not a company name, and not a retirement account. Lenders will only allow you to use 75% of the value of the retirement account as cash reserves. So if you have $100,000 in your retirement account, they’ll only count that as $75,000.
- Lenders want to see you be able to put 10-20% down in seasoned funds. If you sold another property, and received cash out of that, then the lender can see the HUD1 you received at the time of closing and can see the money that came to you as the seller. They’ll count that. Or of course you can have cash in the bank. You can also take money out of home equity or IRAs.
- Lenders also like to see 3-6 months of the mortgage payment in liquid assets in some type of account. Again if it’s in a retirement account, they only allow 75%.
Take advantage of interest only loans.
- Use a 10-year ARM or Balloon. These both lock the interest rate in for 10 years and it makes the opportunity to afford a property much greater.
So how exactly do you calculate a return? Well, this is actually fun to do! If you were to buy a $300,000 property and wanted to calculate total return of that investment, you would include what tax bracket you’re in, depreciation, and positive cash flow. Remember that when a property is considered a second home, you aren’t allowed to deduct depreciation. These equations are also based off of the historical appreciation rates of 6%.
Calculate Your Return: $300,000 Property
Total Return as Investment Property.
Appreciation @ 6% $18,000
Income @ $300 PCF 3,600
(Positive Cash Flow)
- Interest & Deprec
@ 25% Tax Rate 6,250
So if you put $30,000 to purchase that property, which would be 10%, you can see that the return is almost 100%.
Now if you classify that property as your second home it will look a bit different. When you consider your house a second home, you can only rent it for 14 days in a year. But you don’t have to show that rental income on your taxes and you also get to deduct the interest you pay.
Calculate Your Return: $300,000 Property
Total Return Second Home
- Appreciation @ 6% $18,000
- Income: No Cash Flow 0
- Depreciation 0
- Interest @ 25% Tax Rate 6,250
- Total $24,250
So again, if you put $30,000 down, that’s still a very good cash-on-cash return. This is why it always surprises me that many people don’t invest and diversify out of stocks and liquid investments into real estate–and especially into vacation properties.
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