“How do you finance a vacation rental?” is a common question that arises from many people who are considering a rental property purchase.
Owning a home in your favorite travel destination is a dream for most people. Many see a vacation rental as a way to make some extra money, while enjoying time with family and friends in a personal getaway space.
Vacation rentals can be a good investment, and most buyers purchase properties with the intent of generating income and seeing a return on their investment. That’s why it’s crucial for potential buyers to carefully examine what they can afford and the financing options available to them.
The truth is there are many options available for financing a vacation rental, and the process is not a “one-size-fits-all,” says Jeff Chervenak, a certified mortgage planning specialist and president of mortgage broker Guaranty Federal.
Financing a vacation rental depends on an individual’s financial situation, the specific market of the home’s location, and the general real estate ecosystem, he said. We spoke to Chervenak and other experts about what investors should know about how to finance a vacation rental, and they shared some tips.
Take a look at your individual finances
Before getting started with the financing process, Chervenak recommends meeting with a mortgage expert, financial planner, or certified public accountant, and a real estate expert familiar with the location of the home. He said this will help potential buyers get an accurate analysis of their finances, including what they can afford and the best route to take for how to finance a vacation rental.
Dakota Brizendine, partner at Commonwealth Financial Group, said you need confirmation from a financial planner or other expert that you are in a good financial position and that financing a vacation rental is a wise investment and a smart use of capital.
Choose a lender that best meets your needs
Once you’ve taken stock of your personal finances, choosing a lender is the next step. Dock David Treece, senior financial analyst at FitSmallBusiness.com, said buyers have the option of going with conventional or alternative lenders for financing a vacation rental.
Treece suggests meeting with a conventional lender, such as a commercial bank or community bank, first to get a sense of what financing options are available. He said the offerings will likely be similar across most conventional lenders.
“The lineup is typically pretty consistent among conventional lenders,” he said. “And, then you get a lot of variation once you start working with alternative lenders or hard money lenders or other firms like that.”
If the property investor isn’t satisfied with or doesn’t qualify for a conventional lender’s offerings, an alternative lender, which can be a credit union, direct lender, lending marketplace, broker, or other non-bank entity, can be a great resource, he said.
“A lot of those loans have a different underwriting process,” Treece said. “They tend to fund faster, but have vastly different requirements, and each firm often sets their own.”
When going with an alternative lender, he urges potential vacation rental buyers to research carefully, talking to others who’ve used the lender and reading reviews before selecting one.
Finance a vacation rental as a second home
Buyers with higher credit scores and cash on hand may qualify to finance their vacation home as a second home, which is a better option, said Chervenak, who owns a vacation rental in Saint Thomas in the U.S. Virgin Islands.
Going this route means a buyer would have to put up a smaller down payment and would likely get a better interest rate, both of which may vary by lender and the real estate market.
“If you buy a home as a second home, then it’s treated the same as when you buy your primary residence,” Chervenak said. “You just need to be able to support the debt on your income.”
When a vacation home is financed as a second home, a buyer doesn’t necessarily need the rental income to be able to afford the home, he said. But, they need to disclose that they plan to use the home as a rental during the loan process—not doing so could lead to legal troubles. Using a home as a rental will affect the mortgage terms and likely come with a larger down payment.
“Would you qualify without the income? Then, you qualify for this product,” Chervenak said. “If you don’t qualify without the income, then you have to go to a different product. There’s greater risk if you don’t qualify just on your income because you have to generate income for the property to qualify, so there’s a premium as a result.”
According to the National Association of Realtors, about one-third of investors and buyers pay cash for their vacation home properties. Among those who finance their vacation rentals, more than 40% finance less than 70% of a home’s purchase price, and 29% found the mortgage application and approval process for a vacation property to be “somewhat more difficult than expected.”
Finance a vacation rental as an investment property
When vacation property owners need the rental income to be able to afford the mortgage payment or qualify for a loan, they will likely need to finance it as an investment property, Chervenak said.
Financing properties as an investment often means buyers need a larger down payment, maybe around 20%, and the interest rates will be higher. Owners will also need to show rental income projections to qualify for the loan, he said.
In these cases, lenders tend to see rental income as the main source of a loan repayment, and proving anticipated rental income can be difficult, especially if someone is new to the vacation rental investment market, Treece said.
“If someone is buying a property strictly as an investment, and this is true of long-term rentals as well as vacation rentals, a lender will look to the property and the revenue that it can produce as the primary source of repayment,” he said. “And it’s treated as a commercial loan. For that reason, the down payment requirements are typically different and the rates are typically higher.”
Along with rental income projections, buyers will also need to provide well-researched estimated vacancy and occupancy rates to persuade lenders that the property will see a return on investment, Treece said.
Consider a cash-out refinancing option
Another way to finance a vacation rental property is via a cash-out refinancing option, which can help buyers generate capital for the down payment, according to Brizendine.
Cash-out refinancing means investors can use the equity that they have built up in their primary residence, according to The Mortgage Reports. The real estate equity can be used to purchase a second home or an investment property—either for a down payment or to pay the full price of the property.
Lenders will often allow cash-out refinancing that equals up to 80% of equity, according to the report. But, Brizendine said this option often comes with higher interest rates than other options.
Decide what’s motivating you to finance a vacation rental
Deciding which route to take for how to finance a vacation rental often depends on what’s motivating you to purchase the property in the first place, Brizendine said. Your motivations will also help you see whether the investment is a good idea.
“I would say from the get-go, if it’s cash flow positive—if it’s going to generate revenue for you—then it’s typically a good investment,” she said.
Brizendine encourages buyers to look carefully at locations and their reasons for making the purchase before jumping into such a large purchase. That way, buyers can ensure that they’re investing in an asset, which will generate income.
A dual-purpose property, which the owner can enjoy for personal use and then rent out at other times, is the best bet, Brizendine said. Spending time with family at a favorite spot is also valuable. Someone may be willing to spend on these experiences, and this could still make the property a worthy investment.
“I am much more partial towards if you are looking to have a second place to spend time,” she said. “If you purchase an investment property that you’re either managing as a straight rental or through Airbnb or something like that and then the few weeks a year or a few months a year that you’d like to be there, do so. I would say that that’s a much better way to finance a property because you’re going to generate revenue and then it really truly becomes an asset and not just a liability.”
Another tip: keep an eye on the local market, Brizendine said.
“I think paying attention to the market you’re buying a home in to see if it’s appreciating (is a good idea) because there could be some value there even if the property itself isn’t cash flow positive,” she said.
Don’t forget the other costs
The mortgage payment isn’t the only cost that comes with owning a vacation rental property— this is something buyers may not consider, Treece said. And, while some of these costs don’t necessarily impact the financing, the costs are ongoing and could affect the long-term affordability of a vacation rental.
Property taxes, rental income taxes, insurance, utilities, repairs and maintenance, association fees, and real estate closing costs are just some of the extra costs involved with being a vacation rental owner. Treece said taxes are often higher on investment rental properties and vary by location.
The most important thing about investing in a vacation rental, including financing, is whether or not it fits within your budget.
“Not just for the lender’s case, but for their budgeting purposes,” Treece said. “Make sure that they can swing the cost.”
Ready to learn more about financing a vacation rental?
Once you’ve considered all the costs involved with being a vacation rental owner and your reasons for wanting to purchase a property, you should schedule a time to meet with a financial expert to help you go over your unique financial situation to see if it’s a worthwhile investment. Then, seek out a local real estate expert to help you learn more about the market, which will help you better understand whether the investment makes sense long-term.
There are many options available for how to finance a vacation rental, and each comes with a set of unique variables. Having a good grasp of your financial situation and the local market will help you determine which financing option will work best for you.
Not sure how to manage your vacation rental after you purchase it? Schedule a consultation with us here.