Summer is the time for thinking about buying a vacation home.
It's human nature to envision living in places with postcard lifestyles. But the dream comes with a purse-string reality: can you afford it?
"A lot of people say, 'there's a nice town in Maine, so I'm going to buy a house there,' " said Karen Altfest, executive vice president at Altfest Personal Wealth Management.
But the typical second home was worth $475,000 in 2023, versus $375,000 for primary homes, or 27% more, according to real estate brokerage Redfin.
Facing The Financial Commitment
Vacation homes not paid for in cash require down payments and mortgages that charge interest (which sit at a 22-year high of 7% for a 30-year fixed). There are other costs, too, such as maintenance, fees, property insurance and the electric bill. And there's no guarantee that you'll be able to rent it out as frequently as you think to offset costs. Many vacation hot spots are cracking down on short-term rentals via apps like Airbnb.
That's why weighing affordability is key before blindly buying into a more laid-back lifestyle.
"When you're doing research on a vacation home, it's not just saying, 'Isn't this cute? It has a white-picket fence,' " said Altfest. "But instead asking how much are you going to pay every year?"
Setting Your Limit
Altfest recommends clients spend no more than 20% of their net worth on a vacation property to help minimize financial hardships. Your net worth is the value of all your assets minus all your liabilities. So, if your net worth is $2 million, you can shop for properties in a price range of $300,000 to $400,000.
For folks closer to retirement, sticking to 15% is more prudent. Older people have less time to benefit from home appreciation and might have other important uses for their cash, such as health care costs.
"You don't want to put too much of your net worth in any one thing," said Altfest.
What To Know Before You Buy
Location is the most important factor for 70% of aspiring homeowners when buying a second home, according to Pacaso, a co-ownership real estate company. Most buyers (61%) want their second home to be near the water.
The closer to the things you enjoy — beaches, tranquil small towns or restaurant rows — the better. Proximity to your primary home is also key, as a short drive or quick direct flight is better than a 12-hour drive. Two-thirds of people want to commute to their second home in four hours or less, according to Pacaso. It's prudent to buy a place in a spot that you love and will go back to repeatedly without regret.
Whether you will rent it or use it solely for your personal use is another question you'll want to answer. Investment properties generate cash flow to help pay the bills, but renting comes with hassles, such as home wear and tear and added costs for property managers.
Do You Need The Vacation Home
Another big question is whether you will use the vacation property as much as you think.
There are financial plusses to owning a vacation home. It's a real asset that can appreciate in value. If you are successful renting it out, you can earn income while also having someone else help pay down any mortgage or taxes you owe. If you love the place and go there frequently and use it as your go-to vacation destination, you can save on travel expenses like hotels.
But like any investment there are downsides. Market forces can result in you paying too much. Locking in a high-rate mortgage can crimp cash flow. And money tied up in a vacation home can't be used for other things.
Funding Your Vacation Home
Some financial advisors urge clients not to buy a vacation home unless they can pay cash. That's not doable for many people.
But there are some ways to raise capital for a down payment, closing costs and other expenses so you can buy the vacation home you covet.
Pay Cash
If you're flush with cash sitting in accounts, such as money markets, where withdrawals don't result in a tax hit, that's your best option. However, financial pros warn that you should not bring your cash accounts down to zero, either. Make sure you keep your emergency fund intact to cover both emergencies as well as extra costs for your vacation home.
Borrow Against Your Portfolio
Just as your bank allows you to borrow against the equity in your house, brokerage firms can lend you money against the value of eligible stocks, bonds, ETFs and mutual funds in your portfolio if you have a margin account.
Margin loans are generally limited to 50% of the investments' value. The interest rate you will pay varies based on how much you borrow. Currently, margin rates at Fidelity Investments range from 13.575% for loans up to $24,999 and as low as 9.25% if you borrow more than $1 million. These rates are lower than unsecured lending options such as credit cards. You must pay interest for as long as the loan has a balance but there's no set repayment schedule.
One benefit is you can raise funds and keep your money invested in your brokerage account, assuming you keep a minimum level of assets in the margin account to meet collateral requirements. In contrast, "If you sell securities you have to pay tax on the sale needed to raise the capital," said Rob Leiphart, vice president of financial planning at RB Capital Management.
Get A Loan From Your 401(k)
Raising cash from your 401(k) is another option. But tread carefully as you don't want to crack your nest egg. The max you can borrow is $50,000 or 50% of your vested balance, whichever is lower. Benefits include access to cash without going through a credit check and paying back any interest you owe to yourself. Downsides of 401(k) loans include having to pay the loan back quickly if you leave your job or get fired. You'll also miss out on the growth of your retirement account as fewer dollars are invested in the account post-loan.
However, a loan is not a taxable event, as is the case if you simply took a distribution from your 401(k) and paid tax at your prevailing income rate. A sale could also create enough income to boost you into a higher tax bracket, which could prove costly.
"If you take a distribution the main thing to be concerned about is potentially paying more tax on those withdrawn funds," said Leiphart.
Sell Securities From Your Brokerage Account
If you have owned stocks, bonds or mutual funds for more than a year, selling them will allow you to raise cash and most likely pay a lower 15% capital gains tax. This option is more tax-efficient than taking withdrawals from your 401(k) or IRA. Those withdrawals are taxable as regular income tax rates, which tend to be higher.
Tap Your Home Equity
Home prices have risen sharply since the pandemic, despite a surge in interest rates. That means home equity could be a great place to raise funds. Homeowners with home equity lines of credit (HELOCs) have an opportunity to unlock home equity to fund a down payment, says Leiphart.
If you plan on borrowing, doing so in a prudent manner will boost your odds of not getting into financial trouble.
It helps to have your primary house already paid off. And you'll still want to be able to keep funding retirement accounts as well as fortify your emergency fund if unexpected costs arise. Tapping retirement accounts if you're younger than 59-½ is also not advised, as you could get hit with an IRS 10% early-withdrawal penalty.
You're also better off if you set aside 1% to 2% of the home's purchase price for annual maintenance and repairs. So, if you buy a second home worth $300,000, plan on $3,000 to $6,000 annually.
If buying a vacation home will jeopardize your retirement, it's best to avoid the urge, says Altfest. "Using a pension plan to make a down payment scares me," said Altfest.
But there's nothing wrong with buying a vacation home if you can still meet the goals laid out in your financial plan after the second-home purchase. "If you have the money, why not treat yourself to something you really want," said Altfest.
