A vacation rental property serves as a great way to enjoy an area you love while still expanding your portfolio. One of the biggest hurdles for vacation property ownership is getting approved for lender financing. As much as a traditional investment purchase can be difficult, a vacation property goes a few steps further. There are a handful of additional requirements on a vacation rental that go beyond the traditional items needed. These will impact the purchase timeframe, the interest rate and sometimes, even the approval. They will also wear on your patience if you are not careful. Getting approved for a vacation property is far from impossible but does require a few additional steps. If you are looking to make an offer here is what you need to know.
1. Increased down payment. With your average two to four family purchase, you will need anywhere from 15 to 25 percent down. With a vacation rental property you can expect these numbers to increase to 20 to 30 percent. There are some lenders that may allow for a reduced down payment but these programs come with increased PMI (private mortgage insurance) payments and higher than average interest rates. Not only will you need a sizable down payment but these funds need to be seasoned for at least sixty days. This means that the money must be liquid in whatever account you want to use for at least two months. Any funds transferred from one account must be supported with copies of all statements showing the trail of funds. With a vacation rental, there cannot be any down payment funds received as a gift and any joint account holder must give authorization to proceed.
2. Strong credit score. In addition to the increased down payment, the applicant must have a strong credit score. An owner occupied borrower for a single family property can get away with having credit scores as low as 620. With any kind of non-owner occupied purchase, those scores need to be much stronger. Even though a credit score over 700 is considered excellent it may not be enough to buy a vacation rental. With most lenders, the minimum credit score needs to be at least 720. Considering the top credit score is 850, these are elite scores that not every borrower has. With this score, not only can you not have any late payments, you need to have a good amount of available balance on almost all accounts. What further clouds the issue is that this score needs to be the minimum of the three reporting bureaus (Experian, Equifax & Transunion). You can have over a 720 on one account but if the others are lower you will not get approved. The natural instinct may be to keep pulling your credit until you hit the magic number. This is the worst thing you can do. Pulling your credit too many times in a 30 day period will cause your scores to drop. If you don’t have great credit, you can forget getting approved for a vacation property.
3. Low debt to income ratios. One of the calculations that lenders look at to gauge the strength of an approval is the debt to income ratio. This is simply dividing the gross annual income by the minimum monthly payments on the credit report and proposed mortgage payment. Depending on the loan program this number should be under 45 percent. With a vacation property this adds a new monthly payment to your debt number. This can be partially offset by the rental income. Lenders only acknowledge 75 percent of any rental income received. To use this number on a purchase you need to have a signed lease in place and ready to go. Without this you are forced to carry to qualify using the entire new payment as debt. Lenders today are pretty strict on this ratio number and have very little wiggle room to make exceptions.
4. Reserve funds. Having your 20 to 30 percent down payment may not be enough. In addition to down payment funds many lenders require additional money in reserves. With an investment property, the average is anywhere from six months to a year. This means that whatever the full monthly payment is, including taxes and insurance, the lender needs to see that you have these funds available on top of the down payment. These don’t necessarily need to be liquid like your down payment funds, but they do need to be in an existing account.
5. Higher interest rates. Vacation properties are considered a higher risk factor than an owner occupied property. Because of this the interest rate will be higher. You should expect the rates to be anywhere from a half a point to a full point above where current rates are. This has a direct impact on your cash flow if you do decide to rent the property out during the year. It can also make qualifying for the mortgage more difficult. To get under that magic 45 percent number, every dollar counts. An increase in that interest rate may take you over that threshold and cause everything to change.
There are many positives with owning a vacation property. If you do decide to rent it out you can enjoy cash flow at various points of the year. The biggest hurdle is typically getting approved for lender financing. If you can get past this you can enjoy all of the perks associated.