Financing a Vacation Rental Home

Five Tips To Consider When Mortgaging A Vacation Rental

Now that you’ve gone through the steps in deciding whether to buy a vacation rental property, it’s time to consider how you’ll finance it. 

Let’s face it, most of us have indulged in that late night GrubHub delivery or scrambled to find that Uber pick-up after celebrating a night out with friends. The gig economy is forever shaping how people use services and earn income, and real estate is no exception. Over the last few years, companies like Airbnb, HomeAway, and VRBO have changed the way people own and rent real estate.

While income properties have been around for decades, traditional owners will buy a piece of real estate and lease it to tenants with long rental agreements. Investors would seek these longer leases to decrease tenant turnover and lower vacancy costs. Today, thanks to the gig economy, the real estate climate is contradicting tradition, shifting in favor of short-term rental properties.

Short term rental properties, sometimes referred to as vacation rentals, are investment properties (residential in nature) that are rented out for less than a month for any given tenant. Commonly, these properties are non-owner occupied and 1-4 unit dwellings. As short-term rentals demand has increased by consumers, they are becoming increasingly more and more popular with investors.

Financing a short-term rental property can be tricky. Whether you are looking to purchase a new property or refinance an existing property, there are many things to consider when financing a vacation rental.

Here are five tips to consider when mortgaging a vacation rental:

Know the Difference Between a Second Home and a Vacation Rental

Second home and vacation rental are terms often used interchangeably but are not actually the same thing. While similar, it is more correct to refer to vacation rentals as investment properties in the context of obtaining a mortgage. Lenders have different qualification requirements for second homes and investment properties. To distinguish the two, a good question to ask is “who will occupy the property?”  

Second homes must be occupied by the borrower for some portion of the year. Second homes are also restricted to one-unit dwellings, cannot generate income, and cannot be under the contract of a management company that manages its occupancy. This is important to note since personal management with software like PMBO does not constitute a management company. In contrast, investment properties, even short term rentals, are typically non-owner occupied and can be a 1-4-unit dwelling.

Expect to Put More Money Down

Lenders consider rental properties to have enhanced risk compared to a property that was occupied year-round by the given owner as their primary residence. Some concerns with non-owner-occupied dwellings include renter turnover, as well as the general desire to maintain the property. Due to this built-in risk, lenders typically require as much as 15% down on a single unit property and 25% down on a 2-4 unit dwelling for purchase. Compared to a regular purchase (for primary residence) which can require as little as no money down, 15-25% is no small sum. Note, properties, where less than 20% was put down, may require private mortgage insurance accompanied by liquid reserve requirements.

Analyze Market Data for Projected Rental Income

It’s important to validate market trends for how much income a property can expect to reasonably generate. Thus, there are different appraisal requirements for investment properties, usually involving an income approach or analysis completed by a certified appraiser. Do your research to find out how much like properties are typically renting for in your market.  

For purchases, lenders will want to see applicable rental market data on the appraisal report as well as copies of current lease agreements. If the property is not currently rented, fair market rent determined in the appraisal report can be used but is usually discounted at about 75% to account for maintenance and occupancy turnover. If you are looking to refinance a property and have a history or renting it, lenders may use an analysis of your historical rents received and claimed on your personal tax return rather than the data from an appraisal report, depending on the circumstance.  

Bottom line make sure to claim your income if you are looking to utilize the cash flow from the property to qualify for a mortgage. It’s even better if you can qualify for the loan without having to include the projected income from the subject property.

Make Sure You Have Enough Cash

Cash is king! It’s a silly thing to think to note, but make sure you have enough liquid assets to purchase the property. Gift funds have been increasingly popular for new homebuyers over the last few years, but it is important to note that you cannot use gift funds to purchase an investment property. Additionally, make sure you have enough liquid reserves to cover a few months of mortgage payments and be able to substantiate available cash with account statements.

Don’t Misrepresent Your Intentions

Borrowers often try to get around occupancy requirements by indicating they are purchasing a property to live there to get more favorable lending terms. Instead, they never intended to live there but rather rent the property out. This is often referred to as “occupancy fraud,” and it can get you into hot water! Don’t misrepresent your intentions for the property. Underwriters are trained to question and detect discrepancies of this nature.

Get Started

Not all lenders are created equal, and some have more experience with vacation rentals than others. Do your due diligence in working with a lender who has experience with this specific kind of mortgage. You will save a lot of time and potentially money by working with a lender who knows the intricacies of these types of deals. 

Once you’ve made it through the buying process and you’re ready to start making money PMBO vacation rental software can help make management a breeze. Get started today with a free trial, click the button below.

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