Financing the purchase of an investment property is a little different than a home mortgage. Lenders perceive that there is higher level of risk associated with second homes and properties purchased for rental income and eventual appreciation. Statistics indicate that personal residences are better maintained than properties that are not permanently occupied by the owner. Certainly those who experience difficult financial setbacks are far more likely to dispose of investments rather than their home.

There is a significant difference in the standard Fannie Mae and Freddie Mac lending criteria for a second home verses a rental property. A second home is defined as a property that is occupied by the owner at least thirty days each year. Second homes are financed at lower interest rates and lower fees. This may seem like a contradiction to some since they theoretically do not generate income for the owner or at least not as much as a year around rental. Second home financing is considered lower risk to the lender for several reasons.

The primary factor is that since the owner will be occupying the property for some period of time each year there is no way to project the amount of rental income to offset the mortgage payment. Therefore, standard underwriting criteria requires that the borrower qualify for the mortgage on their primary residence as well as the new second home mortgage payment and any other debt that their credit report reveals. Underwriters do not count any projected rental income into their qualifying ratios because it is unpredictable. This is because the owner will occupy the vacation property for some period of time each year. Because it must be in good condition to attract short term tenants, it is likely to be well maintained.

The important difference in qualifying for the rental property is that rental income is considered by the underwriter offsetting the mortgage payment to some degree. When the lender’s appraiser inspects the property to determine the value related to the loan, an analysis is made of comparable rental properties. The appraiser will determine a “fair rental value”. The underwriter deducts 25% of the projected rental value for vacancy and maintenance and the balance is credited as hypothetical income to offset the new mortgage payment and credited to the underwriting ratios. Essentially, if the borrower qualifies for their current mortgage, it is not much of a stretch to qualify for the new payment.

Whereas second home mortgage interest rates are the same or only slightly higher than owner occupied rates, investment property rates are.5% to.75% higher with down payment requirements of 20 to 30%. This is simply the risk verses reward criteria lenders factor into their investments.

Mortgage underwriters are conscious of potential deception by borrowers who reach out for the better terms of second home financing. Other than qualifying for the new property without the benefit of future income, the property should be more than fifty miles from the borrower’s primary residence and make sense as a vacation destination to qualify as a second home. The fifty mile rule takes into consideration that most investors do not purchase rental properties a long distance from home because they are more difficult to manage. There is generally some flexibility in these criteria, particularly when there are special circumstances such as a property to be occupied rent free by a family member such as a student or elderly parent. It is up to the buyer to convince the underwriter that it is truly a second home occupied by the borrower at least 30 days a year. It frequently comes down to a judgment call by the underwriter.

Lenders are suspicious of any scenario that does not meet the strict criteria of second home financing because it is difficult to monitor when or if a second home becomes a rental property. The lender can’t prevent the borrower from renting the property on a long term lease if life circumstances change. There is rarely a restriction of this nature in the mortgage note and enforcement is questionable even if there is.

Over the decades there have been many attempts by mortgage lenders to demand repayment or revise the interest rate on owner occupied mortgages that have become rental properties but few have ever resulted in litigation. It generally comes down to the “intent” of the borrower at the time of loan closing.

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