We all seem to get the itch at one point or another. It tends to start after a memorable vacation that we can’t stop thinking about. Thoughts of buying a vacation home begin to creep in. With mortgage rates near record lows and the pandemic changing how and where many of us work, the idea of purchasing a vacation home has been gaining even more popularity.

As fun as the prospect can be, investing in real estate comes with ample work, especially if it involves buying a vacation rental property.

Deciding to buy a home is often made out of necessity, while purchasing a vacation home tends to be out of desire. It requires a different thought process and approach. Ultimately, whether buying a vacation home ends up being a good investment depends on many factors that you will learn in reading this article.

Points to Consider

Purchasing a vacation property is a significant investment of both time and money. Before you embark on this journey, you should consider these preliminary factors:

Stage of life: Are you starting a family, a soon-to-be retiree, or a retiree? Depending on the life stage you fall into, your household financial obligations may impact the feasibility of making this purchase. If you go forward and invest in a vacation home, you may have to alter your other financial goals significantly.

Job security: As we continue to grapple with COVID-19, some economists worry that the pandemic’s economic fallout will be felt for years. Having job security is paramount since owning a vacation property without a consistent stream of income is extremely difficult.
Finances: Can you comfortably cover a down payment and mortgage? Will you need to rent the home out as an investment property to make ends meet? Keep in mind, ownership comes with many unexpected expenses (more on that below), and because of those expenses, maintaining a larger cash reserve is recommended.
Distance: How close are you to the vacation home you are considering? The farther away you live, the harder and less likely it is you will visit as often as you think. The distance also makes maintenance even more challenging. Or, are you able to work remotely and spend more time there?
Financial goals: Will this purchase potentially delay or alter your other long-term financial goals? If so, those changes must be clearly outlined in your financial plan.

These are some of the important questions you need to ask yourself before moving forward.

Next Steps

Once you’ve considered the items above, the next steps involve zeroing in on what you want and figuring out how much you can qualify for.

You should start this process by engaging a local real estate agent who has experience in vacation properties and vacation rental investments. Your agent can help you narrow your search to a neighborhood or development that fits your criteria and is within your budget.

At this point, it’s a good idea to get prequalified for a loan. The qualification requirements for a vacation home are far more stringent than a primary residence, which means you may not qualify for as much as you think.

While various financing options are available, it is not a “one size fits all” approach. Working with a fee-only, fiduciary financial advisor can help you figure out which strategies are best suited for you. You’ll also want to look at the pros and cons, which we cover next.

Pros

Owning a vacation property comes with many advantages and benefits:

Potential rental income
Possible property appreciation
Tax benefits and incentives
Ability to furnish and renovate as desired
Convenient gathering for family and friends

Plus, with the advent of sites like Airbnb and VRBO, it is easier than ever to list and rent a property while reaching a wider audience.

While the Tax Cuts and Jobs Act (T C JA) changed how tax breaks work, such as lowering the mortgage interest deduction, there are still useful tax breaks with owning a vacation property.

Although short-term rental income and tax incentives are attractive, there are certain benefits you can’t place a price tag on. For many people, purchasing a vacation home provides sentimental value and something they desire to keep in the family for future generations.

It should be noted that there is a big difference between wanting to and needing to rent out a vacation home. If you plan on frequently renting the property, it could end up feeling like another full-time job. You could always hire a property management company to take the burden off your shoulders, but that will cost ~10% of the monthly rental income, which reduces the property’s cash flow.

A vacation home should not be purchased solely for tax purposes. It should be viewed as a potential perk but not the underlying reason.

Cons

There are also cons to owning a vacation property, but by far, the one that most people underestimate is the expense. You should prepare yourself for the following:

Mortgage payments
Real estate taxes
Homeowners insurance
Home repairs and upkeep
Management of the property
Home security system

Unless you pay cash outright, your biggest expense will be the mortgage. A vacation home typically requires a 20% to 30% down payment and will have a .5% to .75% higher interest rate.

While the above expenses are not all recurring, they should be accounted for as such, given that real estate is an illiquid asset. That means you should prepare yourself for the unexpected. When it comes to maintenance costs, experts generally recommend setting aside 1% of the total purchase price of the property each year.

On a $400,000 vacation home, that equates to $4,000/annually.

Many vacation property owners follow the 50% rule, which estimates operating expenses to be ~50% of the property’s gross income. While there are far too many variables, especially given that rental income can fluctuate depending on whether it’s high season, this rule can provide a baseline to work off.

Tip: If the prior owner used the property as a rental, consider asking for a few years of their Schedule E to get an accurate expectation of income.

Bottom Line

Whether a vacation home turns out to be a good investment often boils down to how you plan on using the property.

If the plan is to use it primarily as a vacation rental property, the income plus potential long-term appreciation gives it the ability to be a solid long-term investment. The key is patience, as the upfront costs take time to recoup.

If the plan is mainly for self-use, then the home should not be viewed as an investment but more a source of joy and entertainment.

Bottom line, given all the variables, you should only buy a property that you can afford and not based on potential investment gain.

Discuss your situation with a fee-only financial advisor.

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