By Michael A. Rousseau
Purchasing a home on the beach, a golf course or in the mountains is a dream for many, especially those nearing retirement.
While the number of second home purchases has fallen since reaching peak levels in 2014, stock market gains in the wake of the election, which have swelled many investor portfolios, could have advisors once again fielding client questions on this topic as we head into the summer.
There are a host of financial planning considerations that advisors must help clients mull over before they can even contemplate making such a move. Here are the top four to keep in mind:
1. Liquidity concerns should be different for second homes versus primary homes. It’s seemingly a simple enough question for clients to answer: Do I have enough cash? The problem is, many fail to realize that securing a loan for a second home versus a primary residence is more challenging. Interest rates are as much as 0.5 percentage points higher and the down payment is typically larger, with some lenders requiring up to 30 percent depending on the price. Before the financial crisis, many simply took out a second mortgage to create added liquidity. Banks today, wary of the fallout of another credit bubble, aren’t as willing to play along.
All this speaks to a core financial planning tenet: Clients should always have six months of cash reserves stored up in case of an emergency. If a client, for instance, needs to come with a $100,000 down payment for a $500,000 vacation property, would that eat away at their ability to absorb a serious health scare, job loss or some other emergency? If the answer is yes, then it’s the advisor’s job to make them understand that owning a second home may not be a viable near-term option.
2. Maintaining a margin of error in retirement projections is crucial. Most advisors make long-term projections based on a number of factors, including forecasted rates of investment return, inflation, a client’s spending habits and how much they save each month. Ideally, there’s a substantial gap between how much money a client is forecasted to have via their savings and investments and the amount of income they will need throughout the duration of their retirement. Taking on another mortgage payment, along with other ongoing expenses (regular upkeep, insurance, taxes, homeowner association fees, etc.), would upend a client’s monthly and yearly spending patterns and weaken those projections.
This naturally raises the question of why bother having a second home to retire to if owning one makes it more difficult to retire at all? It’s possible to recoup some of those costs by renting out the property, especially with the emergence of companies and websites like Airbnb that do much of the heavy lifting for homeowners. But advisors need to help clients understand that this may not be an option depending on where they buy. Homeowner associations are increasingly frowning on short-term leasing services, while many others don’t allow for renters of any kind.
3. Always think of the potential tax implications. If a client purchases a home that jeopardizes their ability to fully invest in 401(K)s, IRAs or other tax-advantaged vehicles, they are not only potentially surrendering future returns, but could be setting themselves up for a bigger tax bill in the near term. Indeed, in any given year, there’s a chance that an underinvestment of just a few thousand dollars could place a couple in a higher tax bracket, not to mention how it would impact their retirement time horizon.
This is an especially important consideration for small business owners, who can defer a far greater percentage of their income by creating a company-sponsored retirement plan for their employees. Another tax-related consideration: Clients can’t deduct the interest paid on a second home’s mortgage if the property is rented for more than 14 days.
4. Don't forget about intergeneration estate planning. Let’s say the financials check out. The client has more than enough cash to make the purchase and their long-term financial planning projections are in good shape. There are still intergenerational estate planning questions to consider. While procedurally it’s easy enough for advisors to transfer ownership of the house to the next generation, in cases where there are multiple heirs to an estate, it could get tricky.
What if the beneficiaries each have a different vision for that property? One could want to sell it and reap the financial windfall, while the other may want to assume ownership. Also, if it’s not paid off, one or more parties may not have enough liquidity to keep and maintain it. Every family will be a little different, but advisors should talk to their clients about what’s the best option for them given the circumstances, and revisit this discussion often. As their heirs age, their outlook and financial situation may change.
On one hand, buying a second home is a realization of client’s life goals and a great way to create new memories with family. On the other, it’s a prime example of caveat emptor, because even if they can afford to purchase one in a vacuum, there are a number of other long-term considerations that may make it more out of reach than they realize.
Michael A. Rousseau, CFP® is a financial planner with CCR Wealth Management LLC.