8 Things to Know Before Buying a Second Home in Retirement

Wouldn’t it be great to own a second home in retirement? We have all gone away on vacation and found ourselves in love with the area we are vacationing in. We might have even caught ourselves thinking, “Wow, I could really see myself living here in retirement.” Having two homes in retirement may sound like an incredible retirement. But before you decide to purchase that second home there are several things to consider.

In this article we will cover:

1.      Can you afford it?

2.      Is using a mortgage the best way to purchase it?

3.      How do you properly estimate your second home’s expenses?

4.      What is your second home's potential rental income?

5.      Will your second home be a good investment?

6.      What unexpected costs might there be with your second home?

7.      How well do you know the area where you are buying?

8.      Is it okay to rent rather than own in retirement?

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Can you afford it?

One of the key things that all retirees should focus on is their budget. Very few retirees desire to go back to work in retirement and spending too much in retirement can be devasting. For many retirees, their income is less in retirement. So, it begs the question, can you afford two homes in retirement?

The first step in determining this is to create a retirement budget (Click here to download our Retirement Budget Worksheet) This would incorporate your projected income and expenses in retirement. Next, you would make a secondary budget that would include the additional expenses from owning a second home in retirement.

If you plan to rent this second home in retirement, you will make a third budget that would incorporate any potential rental income or tax deductions that you could receive by renting this property in retirement.

Looking at these scenarios in conjunction with a financial planner can be an eye-opening experience. You will have a much better idea whether you can afford this second home in retirement, or you may be better off owning only one home in retirement.

Is using a mortgage the best way to purchase it?

If you have decided that you can afford a second home in retirement the next step will be to determine the best way to pay for it. Your options include paying cash, using a mortgage, or a combination of the two. With current lending interest rates at all-time lows, using a mortgage to finance part of the purchase price can be a great idea.

Mortgage rates on second homes tend to be higher than primary residence mortgage rates. Even with that higher rate you still could borrow at an extremely low-interest rate to purchase this second home. If you have cash or investments that you are considering selling to pay for this second home, I would think twice.  Many people want to be debt-free in retirement, but this is one of those instances where it could make sense to have some debt. 

If you like the idea of paying down this debt quickly, then taking out a 15-year mortgage is a good idea.  However, this will result in a larger mortgage payment than a conventional 30-year mortgage.  If you like having more flexibility with your cash flow in retirement then a conventional 30-year mortgage will be better. 

Many mortgages today have no prepayment penalty, which means you could always make extra principal payments on your mortgage. If you had more cash flow in some months you could make extra payments and in other months make no extra payments.

If you made extra payments, this would allow you to pay down your mortgage faster than the original mortgage term. However, your monthly payment would stay the same until the mortgage was paid off, refinanced, or you had your mortgage recast or re-amortized.  Recasting or re-amortizing your mortgage will adjust your payment but it will cost you to have this done.

The amount of money that you will need to put down on your second home will depend on whether this will be a second home or rental property. If you will be renting your second home in retirement, then it will generally require a larger down payment than a second residence.

Second homes require a 10%-35% down payment, depending on the lender. Your credit score will also factor in the decision and lenders generally require a higher score between 725 and 750 to qualify for a second home mortgage. If you do not know your credit score you can look it up for free at Credit Karma.  

If you are a veteran, then you should consider using a VA loan.  VA loans are normally reserved for primary residences. However, if you don’t intend to rent your second home you may be able to make your second home your primary residence thus qualifying.  

Getting access to this down payment money can be tricky if all your money is in retirement accounts. However, you have a few options. One would be to take out a retirement plan loan. You can borrow up to half of your 401(k) account or $50,000, whichever is less. You will pay yourself back interest. A bonus to this loan is the bank will not count this retirement plan loan payment in your debt-to-income ratio.

The second option is to take a distribution from your retirement account. If this is a pre-tax retirement account, then this will be taxable income in the year it’s taken.  Also, if you are not 59 and ½ years old there will be an additional 10% penalty on top of the taxes.  Buying a second house is not an exclusion for the 10% penalty as buying a first home can be.

Another choice is to borrow equity from your existing house, provided it has equity. You could do this through a home equity line of credit or home equity loan.  You would want to set up the home equity line of credit in advance of when you are going to buy the second home.  

You will want to speak with a mortgage lender or local bank about your financing options.  It’s best to get multiple quotes on interest rates and closing costs. This will allow you to negotiate to find the best deal as this is a large expense.  

How do you properly estimate your second home’s expenses?

Having a good handle on your second home’s expenses is crucial to managing your budget before and after retirement. If you don’t estimate these expenses properly you could end up having to cut other expenses in retirement. Or even worse, having to sell one of your homes in retirement. You should break these expenses down into two categories: ongoing expenses and upfront or onetime costs. 

For ongoing expenses, these are the monthly or annual fees you will have to pay to maintain the home.  Examples are property taxes, liability insurance, condo fees, water bills, sewer bills, electric bills, cable bills, landscaping costs (snow removal or lawn mowing), etc.  You can ask your real estate agent to help you estimate these expenses, but you should put together your own estimate too.  The current homeowner may also be willing to supply some of this information to you.

For upfront costs, you will want to estimate things you will need to purchase, renovate, or repair prior to you moving into the home.  Most houses that you are going to look at are going to come unfurnished. You will need to make a list of what furniture you will need and how much it will cost.

If you will be renovating the home or there are repairs to be made, you should contact a few contractors to get multiple estimates. You may find that these estimates are in line with what you thought, or you may find that it will cost much more. There should also add some margin for error in your budget just in case you missed something or something unexpected arises.  

What is your second home’s potential rental income?

As you may be starting to realize the cost of maintaining two homes in retirement can be expensive. To offset some of that expense, you may consider renting your second home. Depending on its potential rental income, this might offset much of the annual cost of ownership.

Just like estimating your second home’s expenses, you want to be conservative in its potential rental income.  First, you’ll have to determine how many months or weeks of the year you would like to rent it out.  Once you do that, there are 3 options that I would recommend estimating this potential income.   

Option 1: Have your real estate agent, or a property rental agent put together this estimate.  You will benefit from their experience in knowing this rental market, especially if you do not. However, be careful that they are creating accurate estimates. You don’t want to be told your rental potential is one thing only to find out, in reality, it is another.

Option 2:  Do your own research on sites like Airbnb, VRBO, or Rentometer to put together your estimate of weekly or monthly rental income. You can also try and connect with other renters in the area by calling them or reaching them on social media to find out what their experience has been.

Option 3: My favorite; ask for the last 3 years’ tax return of the current owner.  Specifically, their Schedule E. If the current owner is using it as a rental property, then they are required to file a tax return for the property. On that tax return, it will clearly state last year’s rental income and expenses. If you look at the last 3 years, rather than 1 year, it will give you an accurate picture of what you can expect in the future. If they won’t provide the tax return, then maybe they are hiding something and it’s not a great property for you.  

Will your second home be a good investment?

If you are going to be renting this property out, then you may want to look at it as an investment rather than a second home. By doing this you will be looking at the property’s cash flow potential, rather than amenities or location.

One way to analyze its cash flow potential is to calculate its CAP rate or capitalization rate. It’s an easy formula that you can use for any property you’re considering buying and renting out.

Let’s say for example, that you are considering buying a property for $100,000 and estimate that you’ll be able to rent it out and bring in $10,000 a year in rental income. You would then want to calculate the annual expenses you’d have to pay to maintain the property. These costs as discussed earlier in the article would be things like property taxes, liability insurance, water bills, etc. For simplicity’s sake, let’s just say that those expenses were $2,000 a year.

You would then deduct your estimated annual expenses from your expected income. In our example that would be $10,000 minus $2,000 and would leave you $8,000 profit or what is known as Net Income. You then would divide that Net Income ($8,000) by the purchase price of the property ($100,000).  This would give you a value of 8% or your CAP rate.

This means that if you estimate all the potential rental income and property expenses correctly, this property would pay you 8% per year (before taxes).  Depending on current interest rates and CAP rates of similar properties you would determine if this was a good investment. 

In today’s low-rate interest rate environment, where you are paid almost nothing to keep money in the bank, I would say this would be an excellent investment. The trouble is that many people are looking for investment properties and have bid up the sales prices of these properties. Making it increasingly difficult to find properties with high CAP rates (over 4%).

As a real estate investor, I would not buy properties with less than a 6% CAP rate. Too many other things can go wrong such as unexpected repairs, tax increases, or vacancies that can increase your cost or lower your CAP rate. If you can’t find a property with a good CAP rate, then maybe you need to look in a different area or wait for property prices to come down a bit.

What unexpected cost might there be with your second home?

Are you budgeting for the unexpected?  I know that probably sounds a bit tongue in cheek, but you should have money set aside or be setting money aside for when things break on your second home. Every home no matter how new is going to need maintenance along the way. If you’re buying a brand-new home, then that might be many years off but you should create some type of work schedule on what will need to be done and what it will cost.

For example, the typical asphalt shingle roof lasts about 25 years. How long until your roof needs to be replaced?  How about the heating and cooling system? How old is the current unit? When do you estimate that will need to be replaced and what will it cost?

It is a great idea to have your second home inspected by a professional before you buy it. I would never ever buy a home without an inspection. This will benefit you in two ways: 1) The inspector can help identify any major repair issues that might make you think twice about buying the house 2) You will have an idea of the repairs that need to be done so that you can build a budget and timetable for when you’ll handle them.

How well do you know the area where you are buying?

“Location, location, location.”  These are the top three things that matter in real estate according to Lord Harold Samuel, a real estate tycoon in Great Britain. You can change your house, but you can’t change its location. 

For this reason, many experts recommend that before you move and buy a house in an area that you’re not familiar with you rent there for a little while. This will help you to know the area better and get a feeling of what it would be like to live there. It might also help you to find new up-and-coming areas before others do.  

Even if you’re familiar with the area, you might not be up to speed on its current trends.  By using a Real Estate Agent who is an expert in that area you’ll make sure you’re not buying a house in an area that might not rent as well or be difficult to sell later.

 For example, buying a house that’s on a busy road may make it harder to sell in the future. In a strong real estate market, this may not matter but in a slow or declining market that may make it impossible for you to sell. You want to think of the long-term of this property and not just what your immediate needs are.

If you’ve decided that now is the time for you to buy, and you have children, is there an extra bedroom or two should they like to come to visit? Maybe you don’t have grandchildren yet, but when you do, I’m sure you’re going to want to spend a lot of time with them. Especially if your second home is in a resort community.  

Is it okay to rental rather than own in retirement?

I hear all the time how renting is bad; you’ve probably heard this too.  That if you rent, you’re basically throwing your money away and you’re not building equity. That is true, you’re not building equity. However, you also don’t have any of the headaches that can come with being a landlord or owning a second property. I can tell you as someone that owns rental properties there are many headaches.

You also don’t have any of those expenses! You don’t have to reach into your pocket and pay for a failed air conditioner or a new refrigerator or a new roof. Those are the landlord’s problems. Renting for a specific amount of time at a specific price can be more easily built into your retirement budget than buying a property and not truly knowing what expenses come with it.

Another benefit of renting is that you can go wherever you want. Once you do buy the second retirement home, you’re going to spend more time there because that’s where your resources are going. If you’re someone that’s looking to travel and try out various places, maybe even travel to different countries, it’s going to be a lot easier for you if you only own one house.

Next, if you’re going to rent out your second home, you must ask yourself do you really want to be a landlord? As you’re getting closer to your retirement years, do you want the stress and time commitment of being a landlord? I can tell you that as a landlord, it's great when the tenants are paying, all the properties are rented, and there are no repairs. However, as soon as you have a tenant that’s not paying their rent or is not taking care of the property, the fun is over.

I often tell clients the easiest money they’re ever going to make is from the interest or dividends of their investment portfolio. Rental income is very rarely passive income. Meaning, you just don’t sit back and collect checks without any work. Many times, it is a very hard-earned income.

Having a rental property may be a worthwhile investment, but you must be committed to either managing it yourself or having a slightly lower return and a little stress by using a management company. However, you must be careful that they’re a reputable management company and they’re doing what they say when it comes to supporting your property.