When Graham Gullans purchased his vacation home in Chatham last year, he knew upfront he would finance it with a mortgage. “Mortgage rates were so low that they offered a really compelling reason to buy a second home,” said the 37-year-old tech company executive, whose primary residence is in Boston.
Gullans locked in a 2.75 percent mortgage to purchase the property, which consists of a main house and a separate carriage house totaling four bedrooms and five baths, for $1,176,000.
Today, however, deciding how to pay for a vacation home may be more challenging. According to Freddie Mac, a 30-year fixed-rate mortgage averaged 5.25 percent as of May 19, up from 3 percent one year earlier. Higher interest rates, which translate into higher mortgage payments, cut into the purchasing power of a vacation home buyer. Plus, with limited inventory and strong buyer demand, the market is more competitive than ever, so some shoppers are becoming more creative to nab that perfect weekend place.
“The local residential market is very competitive, so people are doing things a bit differently,” said Mary Mullin, a wealth management adviser for Merrill Lynch Wealth Management in Boston. “Ideally, you want to go in with a cash offer.”
Mullin said that in the past, if someone owned a home in Boston or the suburbs and wanted to buy a house on the Cape, they would do a cash-out refinance. But despite the fact that tappable equity — the amount homeowners can access while retaining at least 20 percent equity in their homes — increased by 35 percent in 2021, to an aggregate total of nearly $10 trillion, according to mortgage technology and data firm Black Knight Inc., many vacation home buyers don’t have sufficient equity in their homes to pay for a second property. Plus, Mullin said, many of her clients don’t want to refinance now anyway because interest rates are so much higher.
But a home equity line of credit (HELOC) allows homeowners to tap the equity in their primary home while keeping the underlying first mortgage in place. And even if that equity isn’t sufficient to pay for the entire purchase price of a vacation home, it might allow a buyer to increase the amount of their down payment to compete better against other bidders.
Another option is to liquidate investments to generate the cash to pay for a vacation home, but that can lead to tax liability. “People don’t want to cash out a portfolio and pay capital gains tax,” Mullin said. The solution: a line of credit secured by the investment portfolio, which gives buyers the ability to make a cash offer. Then, after they close, they can mortgage the vacation home and pay off the credit line. “It’s a good strategy,” Mullin said.
Still, many vacation home buyers will finance their purchase with a traditional mortgage. Patti Lotane, a mortgage loan officer for Cape Cod 5 in Chatham, said interest rates at the state-chartered savings bank are the same for both primary and vacation homes. Applicants need to put down a minimum of 10 percent, or 20 percent to avoid private mortgage insurance. Those who need rental income to qualify for the mortgage, or who apply for a jumbo loan, will need a higher down payment — up to 30 percent, Latone said.
In January, the Federal Housing Finance Agency announced increases to Fannie Mae and Freddie Mac’s upfront fees for second-home loans, effective April 1, 2022. These fees make financing a second home with a mortgage that will be sold to Fannie or Freddie a lot more expensive.
“Starting with deliveries to Fannie and Freddie in April, there are new fees applicable to second homes,” said Bill Banfield, executive vice president of capital markets for Rocket Mortgage, headquartered in Detroit. “They range from 1⅛ points to 4⅛ at the highest loan-to-value ratio [LTV] and lowest FICO score.”
For someone with good credit and a 75 percent LTV, Banfield said, the fee would be 2⅛ points, or $8,500 on a $400,000 mortgage. “It has put a little bit of a ding in the financing of new purchases of second homes,” he said.
Allison Cameron Parry, a real estate agent with Douglas Elliman Real Estate whose market area is Nantucket and Martha’s Vineyard, said that for purchases up to $6 million, her buyers are still using some sort of financing. At higher price points, she said, many pay cash.
Her clients also are getting creative to finance their vacation homes. Some are having parents co-sign their loan so they can qualify, while others are purchasing second homes with friends or family members to share the costs. Those who plan to use their vacation home as a business or investment property by renting it out might, subject to Internal Revenue Service rules, qualify for a 1031, or like-kind, exchange. Cameron Parry said a recent client did just that, selling a condominium on Cape Cod and swapping it for a home on Martha’s Vineyard while rolling over the gain and deferring capital gains taxes on the sale.
The method you choose to finance a vacation home will ultimately depend upon your individual financial situation and risk tolerance. That’s why consulting with an accountant or financial planner upfront is wise.
“If you’re trying to weigh whether you should get a mortgage, liquidate savings, or take money out of a retirement account, first look at what it’s going to cost you in taxes,” said Mullin, the wealth management adviser. “Then look at [your] monthly cash flow. You may be able to afford the 20 percent down, but what will the payments do to your monthly budget?”
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