You may have seen news headlines that the average mortgage rates in the U.S. are at nearly all-time lows. That’s true, but you can also be pretty certain that the average rates you may see listed refer to mortgages made on primary homes -- that is, homes people intend to live in full-time.
If you’re planning to finance a second home or investment property, the rates you get offered can be significantly different. With that in mind, here’s the difference between second homes and investment properties, why it matters for financing purposes, as well as some current examples of mortgage rates for each type of loan.
What’s the difference between second homes and investment properties?
The exact definition of a second home depends on who you ask, but the generally accepted rule of thumb is that a second home is a residence that you use some of the time, regardless of whether it’s used as a rental property or not. On the other hand, an investment property is one that you don’t use at all for personal purposes -- the only reason you own it is to generate rental income.
Furthermore, a second home can have only one living unit, such as a single-family home or a condo. In contrast, an investment property can have as many as four rental units before it needs to be considered as "commercial" in nature.
The IRS has a more specific definition that is used for tax purposes. In the eyes of the IRS, in order to consider a property a second home, you must use it for at least 14 days per year or 10% of the number of days it’s rented out, whichever is greater. In other words, if you have a property that rents for 200 days in 2019, you need to personally use it for at least 20 days in order to consider it a second home.
Many lenders use a similar definition of a second home. Others have a looser definition that requires you to simply use the property at some point during the year. And some have strict definitions -- there are lenders that won’t finance a second home if you plan to rent it out at all. As you’ll see in the next section, the distinction between a second home and an investment property can have major implications when it comes to financing.
Why it matters for financing
First off, it’s important to note that second homes and investment properties are seen as "riskier" loans than primary residence mortgages, so you can generally expect to pay higher interest rates for them.
You also need to know that a second home mortgage and an investment property mortgage are two different loan products in the eyes of lenders. The Fannie Mae and Freddie Mac lending guidelines (which are used by most lenders that originate conventional mortgages), have completely separate minimum lending standards and definitions for second home loans versus investment property loans.
One major difference is the down payment requirements. Fannie Mae’s minimum standard for second home loans is a 10% down payment, while investment property loans require at least 15%, and as much as 25% or more in many cases. In a nutshell, second home loans represent less of a risk to the lender. Think of it this way -- in tough times, people will generally prioritize properties that they use over those that are purely for investment purposes. It’s also easier to get mortgage insurance for an owner-occupied property, which is a requirement with less than 20% down.
Also, because of the perceived higher risk, second home mortgages also tend to have lower interest rates than comparable investment property loans.
Under Fannie Mae’s rules, you can rent out a second home, if the following conditions are met:
- The property must be occupied by the borrower for some portion of the year.
- A second home must be a one-unit dwelling.
- The home must be suitable for year-round occupancy.
- The borrower must have exclusive control over the property.
- It cannot be a rental property or subject to a timeshare agreement. However, there is the footnote that: "If the lender identifies rental income from the property, the loan is eligible for delivery as a second home as long as the income is not used for qualifying purposes, and all other requirements for second homes are met (including the occupancy requirement above)."
- The home cannot be subject to any agreements that give a management firm control over the occupancy of the property.
When it comes to a second home, your lender may allow you to rent the property when you aren’t using it, but you can’t use that rental income to help you qualify for the loan. You’ll need to qualify for a second home based on your own income and debts.
On the other hand, one of the advantages of investment property mortgages is that rental income can be considered for qualification purposes. With conventional mortgages, you can use as much as three-fourths of the expected rental income to help you qualify for an investment property loan. And there are some investment property lenders that only consider the property’s income, not your own (they’re known as asset-based lenders).
It’s also important to mention that different lenders have different standards when it comes to second home and investment property loans, in terms of rentals and personal usage. Most investment property lenders won’t let borrowers use the property for personal use at all and will even make you sign something promising that you won’t.
These definitions matter because if you agree to a particular lender’s definition of what your property type is, and don’t abide by it, you’re technically committing mortgage fraud. So be sure to ask what the specific definition is, and only agree to the loan if their definition meets your needs.
This is just a snapshot
As a final thought, it’s important to realize that market interest rates are constantly changing. In fact, the 10-year Treasury yield dropped by two basis points in the time it took me to write this article. And when market interest rates change, mortgage rates tend to change as well.
The point is that the rates I mentioned in the last section are just a snapshot in time and will vary over time. They might be substantially different by the time you’re reading this. Having said that, it does illustrate the difference between the two. So decide which type of financing (second home or investment property) is most appropriate for your situation and shop around for the best rates with a few different reputable lenders.
Examples of second home and investment property interest rates
While mortgage rates fluctuate over time, here's a quick example of mortgage rates as of September 6, 2019, to give you an idea of what to expect. The average conventional 30-year fixed-rate mortgage loan has an APR of 3.875%.
Meanwhile, the cheapest APR on a second home mortgage I could find with a quick search is 4.080%, and that's for borrowers with excellent qualifications. And while investment property mortgage rates can vary widely, most reports indicate that with a conventional loan, you should expect to pay an APR that's 0.50%–0.75% higher than a comparable primary residence mortgage. That means that the average APR should be in the 4.375%–4.625% range based on the current primary residence average.
Also, don’t forget about origination fees or points. You may get offered an investment property loan with a seemingly low interest rate, but the origination fee, or "points" that you have to pay to get that rate can significantly increase your cost. The APR is the best way to make apples-to-apples comparisons between different mortgages, so be sure you’re using that to compare, not just the nominal interest rate.