Your Dream Vacation Home: To Buy or Not to Buy
January 15, 2020 Author: Tess Downing, MBA, CFP®, Complete View Financial
When you reach that point in life when you can afford to allocate funds to nice-to-haves rather than must-haves, it’s still important to make smart financial decisions. After all, no matter how much money you might have, the way to maintain your financial security is to spend it wisely. One of the nice-to-haves many people consider is a vacation home. That begs the question of whether to buy such a home or simply rent one. Let’s look at some of the considerations that go into this decision.
Investment or Liability
At the outset, you need to understand what a vacation home represents financially. Many buyers go shopping for a second home with the conscious or unconscious assumption that they are buying an investment. We argue that buying a vacation home is more of a lifestyle decision than a financial investment decision.
In fact, we would argue that viewing even your primary residence as an investment is faulty logic. No one would blame you; Americans have been conditioned to think of their homes as piggy banks that can be emptied with a home equity loan or line of credit and told repeatedly that real estate always appreciates in value. As is the case elsewhere in the financial world, past results are no guarantee of future performance, as the real estate bust that in many areas accompanied the 2008 financial crisis should have taught us.
First, rising prices are supported by an ever-growing pool of buyers, and as the Baby Boom generation ages and Millennials wait longer to buy first homes, that foundation is shrinking or gone entirely in many areas. Consider Detroit, where municipal authorities are literally bulldozing homes because there are no buyers. That means your home value could very well stagnate or even decline.
Second, investments need to be at least somewhat liquid. If you choose to own non-financial assets like gold coins, artwork, or collectibles, those can be sold for cash fairly readily, although the process can take a while and you may not get what you think they’re worth. More importantly, you don’t need them to live; you might love that painting, but if you need the cash more, you can do without it. If you sell your home, however, where are you going to live? If your mortgage was paid off, you’ve just created a new expense — rent — for yourself, and even if not, you’ve just traded a mortgage payment for rent.
To reiterate, the lesson here is homes are not financial investments. Yes, a paid-off home is a valuable and important component of your retirement, because it provides a low-cost place to live. (You’ll still have taxes, insurance, and maintenance.) It is not a source of cash, however.
Vacation homes are not an investment, either. Yes, you can sell one and still have a place to live, but if you’re buying one assuming that you could always sell it for more in the future, there are no guarantees. It’s not outright speculation, but it’s close.
Cash In vs. Cash Out
Buyers often assume that they will purchase a vacation property, use it a few weeks a year, and then rent it out the rest of the time. The rental income, they reason (or a real estate agent might argue), will cover the mortgage and expenses and maybe even provide some additional income.
More often than not, vacation homes end up more money pit than cash cow. Here are some reasons:
- Assuming that you finance the property, you will have a monthly mortgage payment. However, few vacation properties can be successfully rented out all year long. Even relatively balmy locations like the Florida panhandle aren’t particularly popular in, say, February, and in any event, rental rates are seasonal. In other words, you can’t count on a steady revenue stream.
- The property will have monthly utility expenses. Sure, costs like electricity and water will be minimal when the property isn’t occupied, but others like cable and internet will be steady month to month (and yes, your rental guests will expect access to internet service at the very least).
- You’ll need a property management company to handle the vacation home unless you live near enough to do it yourself and also have the time to do so. Their services aren’t free.
- Vacation homes are often located in coastal locations, and insuring against flood and storm risks will likely be much higher than what you’re accustomed to paying for your primary residence.
- Vacation homes have maintenance costs just like any other home. The rule of thumb here is 1% to 2% of the home’s cost annually.
- Bear in mind that assuming you rent the home out for more than 14 days annually, any net rental income is taxable. That also means you’ll need to account for all related expenses and allocate between rental use and personal use. If you can’t do it yourself, you’ll need to pay an accountant.
Even if you pay cash for your second home (and many experts would tell you that if you need to finance such a property, you shouldn’t buy it), you must confront the question of whether those funds could have earned a better return elsewhere. That depends on an honest assessment of the net profit it will generate — so see the list of issues we just raised above.
Rent vs. Buy
We’ve all been conditioned to resent paying rent rather than paying to eventually own an asset. Even when it comes to a primary residence, renting can in some circumstances make more sense, but renting a vacation home is usually a better financial choice than buying. We’ve already outlined the financial rationale. Renting is a predictable expense; buying a vacation home is a journey with some uncertainty.
There are also some basic lifestyle questions. Are you sure you want to return to the same vacation spot year after year? Even if you are, what if something you particularly like about the area changes? Maybe it’s a wonderfully quiet and secluded spot . . . until someone decides to build a condominium or resort development five years from now. Maybe it’s a hot spot for thirtysomething vacationers with kids . . . perfect for you now, but will they get on your nerves in 15 or 20 years? What if your kids grow up and don’t really want to vacation there any longer?
Probably the most valid exception to all of this is a second home that you plan to occupy as your primary residence in retirement. Even if you finance it, presumably you would pay off the mortgage with the proceeds from the sale of your current home, so no issues there. However, the same questions about whether you’ll love the place as much in 20 or 30 years as you do now holds true. You also need to consider how your lifestyle will look in retirement. For example, does the home have easy access to a range of medical services? Is it close to a transportation hub like an airport? Are there plenty of providers who can perform repair and maintenance services on the home?
Buying a vacation home is not necessarily the wrong choice, and as with any significant financial decision, you should seek the advice of a professional advisor. However, it’s important to make the decision based on a clear understanding of what a second home is and is not and to avoid overly optimistic assumptions about what income it might generate.
For more things to consider before buying a vacation home, read here.