Investment property interest rates vs primary residence

If you’ve been comparing mortgage rates for the purchase of a second home or an investment property, you’re already on a promising path: You’ll either have a place to go for vacations, or you’ll have a place that’ll generate income and put more money in your pocket.

Either way, the opportunity to own more than one property is an enviable position to be in, but how you classify that property makes a difference in how much you’ll pay to finance and own it.

Second home vs. investment property

Are you buying a second home, or are you making an investment?

This might be confusing, especially if you’re thinking about occasionally renting out the property — using it regularly for vacation, for example, but also making it available on Airbnb for some of the time you’re not using the property.

Earning some money from your property doesn’t automatically make it an investment, however. Accurately defining the piece of property depends on how much time you spend in it.

Elliot Pepper, co-founder, CFP and director of tax at Northbrook Financial in Baltimore, says that you need to pay attention to what he calls “the 14-day limit rule.”

“Very broadly speaking, if you personally live in your second home for 14 days or fewer — or less than 10 percent of the days it is rented — during a year, then it would be considered a rental property and the income earned would be taxable,” Pepper says, “but you would also deduct the expenses associated with the property.”

On the flip side, if you use the property for more than 14 days or more than 10 percent of the time it’s rented, any rental income you receive isn’t taxable, but you also can’t deduct expenses, Pepper says.

In general, a second home is like a vacation home — one you purchase for enjoyment purposes and live in during part of the year. In contrast, an investment property is one you plan to rent out with the goal of generating income.

Lender requirements for second homes vs. investment properties

Second home lender requirements

• Minimum credit score: 620-680 or higher
• Minimum down payment: 5%-10%
• Maximum debt-to-income (DTI) ratio: 45%

Investment property lender requirements

• Minimum credit score: 700 or higher
• Minimum down payment: 15%-25% or more
• Maximum DTI ratio: 45%

Making the distinction between a second home and investment property is important not only for tax purposes, but also for when you seek financing for the home.

Julienne Joseph, former assistant director of government housing programs at the Mortgage Bankers Association, says that credit score and loan-to-value ratio (LTV) requirements vary based on what the buyer plans to do with a property.

“Investment properties typically have more stringent underwriting guidelines than second homes and primary residences because there is an assumed [greater] risk of default on properties that borrowers don’t occupy,” Joseph says.

Put another way, if a borrower has trouble making mortgage payments, they’re more likely to keep up with the payments on their primary residence, which they live in more often, than payments for a second home — a riskier prospect for lenders.

The stricter standards for an investment property might also include a larger down payment requirement.

For instance, Navy Federal Credit Union requires a 25 percent down payment for an investment property, but if you’re looking at a second home, the down payment could be as low as 5 percent.

That’s a huge difference: For a home with a sale price of $500,000, second-home buyers might be able to put down just $25,000 (or 5 percent), while investment property owners would need to come up with $125,000 (or 25 percent).

Mortgage rates for second home vs. investment properties

While mortgage rates are still low historically-speaking, they’re on the rise, and in general tend to be higher for second homes and investment properties, since they are riskier prospects for lenders.

Tax implications for second home vs. investment properties

Second home tax implications

• The mortgage interest on a second home is tax-deductible so long as it falls within the $750,000 total debt limit and you don’t rent out the property for more than 14 days per year.

Investment property tax implications

• The mortgage interest on an investment property is fully tax-deductible. You can also deduct many expenses related to the property, including property taxes, maintenance and insurance, as well as for depreciation.
• If you rent out the home for more than 14 days per year, the rental income is taxable.

Homeowners enjoy the ability to deduct mortgage interest, but Pepper points out that this can get a bit tricky if you own a second home, due to the $750,000 total debt limit for interest deductions. Essentially, if you have more than $750,000 in mortgage debt between the two (or more) properties, you’ve maxed out the amount you can use to deduct interest.

For an investment property, however, the rules are different.

“Interest on a mortgage related to an investment property is fully deductible on [Form 1040] Schedule E for a taxpayer and can therefore be used to offset any income generated from the property,” Pepper says.

In addition to deducting mortgage interest, investment property owners enjoy the ability to deduct a wide range of expenses. The IRS says the following costs are deductible:

• Property taxes
• Advertising the property to attract renters
• Maintenance
• Materials and supplies used for the upkeep of the property
• Utilities
• Insurance

If you hire someone to do the work, too, such as a carpenter or an electrician, you can deduct their wages. However, you’re not allowed to deduct the cost of a renovation to improve the property.

On the opposite end of improvement, Pepper says that investment property owners can use depreciation to their advantage, as well.

“For a personal residence, the owner is not allowed to deduct the actual cost of the home for tax purposes,” explains Pepper. “However, for an investment property, the taxpayer will be allowed to take a deduction every year for depreciation. This deduction is based on the price of the house purchased and will be used to offset any income from the property.”

Pepper notes that this deduction isn’t a permanent write-off, “as the amount of depreciation taken will reduce the basis in the house. When the taxpayer goes to sell, they may end up with a larger tax gain that year.” This gain, known as depreciation recapture, is taxed at higher rates than traditional long-term capital gains.

In addition, whenever the selling year arrives, an investment property owner can be subject to income tax if the sale results in a profit, Pepper says.

For more on the tax implications of second homes and investment properties, review IRS Publication 936 and Publication 527.

Can you call an investment property a second home?

Tempted to call your investment property a second home and take advantage of some of the second-home perks, like a lower down payment and interest rate?

Don’t be. In the mortgage world, you need to call it what it is — whatever “it” may be.

“It is absolutely imperative that borrowers are completely transparent when disclosing to their lender the intended use of the property to ensure that they receive the appropriate product and rate,” Joseph says.

Joseph adds that borrowers may be asked to sign a document verifying their intended use of the property, so they’ll have to indicate in writing what they plan to do with the home. Deceiving a lender otherwise could have serious consequences.

“Intentionally misleading a lender constitutes mortgage fraud,” Joseph says. “Not only is it unethical, it’s illegal and could result in criminal prosecution.”

What is the average interest rate on an investment property?

How much higher is the interest rate on a second home?