Purchasing a Recreational Property – Vacation Property Financing
This is part three of my three part series on refinancing to invest or purchase other properties.
Many buyers assume that the rules that apply to buying a recreational (vacation) property are the same as those that apply to buying a home. This is incorrect. The rules for obtaining financing on a recreational home are very different as there are a number of new concerns that the buyer likely doesn’t face on their existing home.
When purchasing an owner-occupied property (your home in which you live) the government will let you purchase with 5% down (until October 15, 2008 you can actually buy with 0% down). However, when purchasing a vacation property (which likely does not have a steady rental income) you will be expected to put up a larger down payment. If the property is VERY rural and is, say, located on an isolated lake with no power and a gravel road, you likely will have to put up a much larger down payment (could be as high as 35% or 40%) depending on the property. When most buyers see 35% down they immediately ask “why???” and the answer is not straightforward. However, if it was summed up in a single word, it would be “property.”
HOW PROPERTY AFFECTS THE BANK’S SECURITY
When the bank does a mortgage on a property, they are looking at the deal as a “what if the worst case scenario happens ” type of basis. They want to be sure that if they have to foreclose on the property and take it away from you, that they can sell it in a reasonable amount of time and get their money back. Recreational properties (rec properties for the rest of this article) are much harder to sell in a quick sale, and often stay on the market for many months (or even years) before a buyer makes an offer. This problem is amplified even further if the property is located in a very remote location. If the property is just raw land that you intend to use for future construction, financing may not even be possible at 50% of the price as lenders will have an even harder time offloading the property in the event of a foreclosure. If you go far into arrears and are unable to make payments (regardless of the reason) the bank could be using that money elsewhere with a paying client. There is an opportunity cost that they face by lending you the money – that cost is the opportunity of lending it to someone else. If you are in arrears, and as the arrears pile up, the equity you have in the property gets eroded more and more with each passing month. If the bank is foreclosing and they want to drop the price a bit to get a faster sale, they can’t if the interest has piled up and if you didn’t have a large down payment in the first place. For this reason, they will want a larger down payment the further and further out the property gets and the more remote its location. For this reason, the property is the most important issue.
A FEW NOTES ON INCOME
You will need to be able to show sufficient income to cover your existing mortgage payments (if applicable), all other debt payments, and the new mortgage payments. While this sounds straightforward, it becomes surprisingly hard if you are paid commissions, work a lot of overtime, or are self employed. While proving the income might not be impossible, doing so in a manner that satisfies the lender that you can afford the payments may be difficult.
WHAT ABOUT THE SEASONAL RENTAL INCOME THAT THE PROPERTY MAY GENERATE?
Perhaps you have plans to rent out the property most of the year to vacationers and only use it yourself for a few weeks a year. This could generate a healthy bit of income. However, this is a very tough number to predict unless you have a regular tenant in the property, and in most recreational areas, this is not possible. Unless there is a contract with a certain amount of rental income guaranteed every month, the bank will not factor in any rental income. If they do, this property couldn’t be used for recreation and would be a standard investment property and would fall under standard investment property guidelines. Given the importance of property to a bank’s lending decision, a recreational property would likely make a poor investment as rental income would be very limited if at all available – depending on the property’s location.
THE IMPORTANCE OF RATE
Many times, banks flat out refuse to finance certain recreational areas or rural areas due to internal policy. There can be a number of reasons for this, but it is usually driven by the bank’s own guidelines and desire to lend on properties in “prime” areas that are saleable quickly and with minimal hassle in the event of foreclosure. If the banks decline you, that does not mean you cannot get financing, however. There are several non-conventional or non-conforming lenders that will charge a higher rate of interest, but who WILL lend on hard to finance properties. Many of these lenders (perhaps 99% of them) only deal with mortgage brokers, and for this reason you should seek out the services of a qualified mortgage broker who can connect you with lenders across the country that will lend on rural or rec properties. This is commonly referred to as “Private Financing” and is often more expensive. Private mortgage rates, historically, have ranged from 9% to 15% depending on how rural the recreation property is, what percentage of the property’s value you will be borrowing, and the credit worthiness of the borrower. The good thing about private financing is that income often doesn’t matter, and for this reason, a lot of recreational properties are financed this way.
WHAT IF THE LAND MAY HAS A LOT OF DEVELOPMENT POTENTIAL OR LARGE ACREAGE
This actually makes financing even harder as the banks generally do not like to finance raw land. They usually will only lend based on the house (or cabin) on the property and 10 acres of land. Otherwise the deal becomes predominantly a land deal and they treat it as such, even if it has two homes on it! Development potential is also very difficult to finance because the banks are being asked to lend money TODAY based on the value TOMORROW. This is something that they simply will not do. If a property has a lot of development potential built into the price, or is very large acreage, this can make financing it very difficult.
DETERMINING VALUE
When you are buying a rec property for, say, $200,000 the banks will only lend whatever they will lend. However, they will not base it on the purchase price. They will base their willingness to lend on the “appraised value” of the property. They will almost certainly demand that an appraiser (often from their list of approved appraisers) drive to the property, walk around on and in it, take photos, and prepare a lengthy and detailed report. In a normal purchase of a normal property in a city, the cost for this usually is less than $300. However, with a recreational property, often in a remote location, the appraiser has to drive far out of their way to get to the property and the cost can run as high as $800 or $1,500 depending on the lender’s requirements. For this reason, it is good to have an appraisal in hand BEFORE going to bank for financing as it will guide their decision much more strongly than in traditional purchase situations.
Clearly, there are a lot of concerns when buying a recreational property, and it is a good idea to talk to a mortgage broker that is used to financing properties in remote locations with unique characteristics. As their advice often costs nothing to obtain, it is in your best interests to seek one out to shop for you and get the best rate, terms, and structure that fits your unique financial situation.
