How Does a Second Home Impact Your Finances?
I recently was asked an interesting question. What is the most impactful financial advice I’ve given since I started working as a financial planner? Financial advice is often synonymous with investment advice. However, my answer had nothing to do with portfolio management.
I’ve helped multiple clients understand the financial implications of buying or owning a second home. It may be a good lifestyle decision for some people.
However, it can have a massive financial impact that many people don’t understand. It also provides an interesting case study in using retirement calculators to see the impacts of different financial decisions.
Let’s dive into the numbers behind this decision….
Is Real Estate a Good Investment?
A commonly held belief is that real estate is a good investment. This idea has been called the “American religion.” Many people then use this belief to justify buying real estate at any cost.
What is a Good Investment?
It’s helpful to start with a framework for any investment from stocks to bonds to investing in furthering your education. This framework also applies to real estate.
When considering whether something is a “good investment” for you, consider your costs, the anticipated returns, and the associated risk.
Costs are not limited to the initial price of the investment. What are the ongoing costs, both in terms of time and money?
What are the opportunity costs of this investment? We all have limited resources, so time and money applied to a particular decision are time and money that can’t be used for other things.
The same considerations should be given to return. What is the size of the return you anticipate? How much variability is there around this return? What are the non-financial rewards? How do you value and quantify them?
When evaluating any investment, risk must also be considered. Do the potential rewards justify the risks? Are there ways to insure your downside? Can this investment derail your ability to reach your goals?
Evaluating Real Estate as an Investment
Once we establish a basic framework for an investment, it is important to develop a framework to understand the financial implications of real estate specifically. All real estate is not equal.
Let’s examine the financial impacts of:
- A rental property
- A primary residence
- A second (or vacation) home
The Finances of Rental Real Estate
When considering real estate investments, I found the I.D.E.A.L. acronym introduced to me by real estate investor Chad Carson useful. I.D.E.A.L. represents the financial benefits you may enjoy with real estate investments. It stands for:
- Income: When you buy a rental property, the rent payments you receive (hopefully) every month provide income. Rents tend to increase over time, giving you a built in inflation hedge.
- Depreciation: Depreciation is a paper expense you are required to take when you rent your property. You are required to depreciate residential real estate over 27.5 years. This expense is a deduction against the income you receive, making rental income more tax-efficient.
- Equity: Assuming you purchase your property with a mortgage, a portion of each rent payment builds equity in the property, gradually increasing your net worth over time.
- Appreciation: While you depreciate your property for tax purposes, real estate prices typically appreciate over time. A fair assumption is that real estate will match the general inflation rate, though there are times and places where real estate can appreciate much faster, slower, or even lose value. Consider appreciation a likely benefit, but rely on it for the success of your investment.
- Leverage: Using a mortgage to purchase your property allows you to fully control an asset while applying only a relatively small amount of capital. Interest on the loan is also a deductible business expense, making rental income more tax-efficient.
Related: 5 Lessons Learned In My Year as a Landlord
The Finances of a Primary Home
I don’t consider a primary home as an investment. Using the I.D.E.A.L. framework, there is no income and you don’t get to depreciate your residence. Simultaneously, housing represents the largest expense for most households.
A better framework is to consider your home as a consumption item that ties up capital and time while creating ongoing expenses including insurance, taxes, repairs, maintenance, and improvements. That said, home ownership comes with several financial benefits while providing a place to live.
The equity in your home is an asset. A mortgage creates a form of forced saving every month.
Your home also offers an inflation hedge. As noted above, homes typically appreciate in value over time. If you purchase the house with a fixed-rate mortgage, your principal and interest payment will remain fixed. However, you will be paying that expense with dollars that are becoming worth progressively less due to inflation. This effectively lowers your housing costs over time.
Interest on a home mortgage may also provide an itemized deduction to lower your tax bill. However, many taxpayers don’t have enough deductions to itemize. Your mileage may vary.
Related: What Are the Financial Advantages of Home Ownership?
The Finances of a Second (Vacation) Home
I’ve covered rental real estate and home ownership extensively on the blog. I haven’t devoted attention to second homes. This topic was never of much interest to me personally. I didn’t appreciate how many people would be interested in it until encountering this with a surprising (to me) number of planning clients.
Now that I’ve seen how common this desire for a second home is, I decided to take a deeper dive into the costs, benefits, and risks associated with this decision.
Costs of a Second Home
The costs of a vacation home are very similar to those of a primary home. In some cases, they may be more if the second home is in an expensive area (as vacation homes tend to be).
All expenses you have with a primary home (outlay of capital and/or regular mortgage payments, insurance, taxes, repairs, maintenance, etc.) come with a second home as well.
Remember, housing is the largest expense for most households. It’s not hard to imagine that adding a second set of these expenses will dramatically change most people’s financial projections.
A high-fidelity financial calculator is useful when assessing the impact of a second home. In my financial planning practice, I use RightCapital with my planning clients. Both Boldin and Pralana retirement calculators we affiliate with allow this type of modeling.
Impact of a Vacation Home on Financial Projections
People often agonize over what they think are important financial decisions.
- What is the ideal asset allocation?
- When should I claim Social Security?
- Should I convert my traditional retirement accounts to Roth?
In reality, these decisions often don’t move the needle much. Sometimes they may even produce conflicting results in financial calculators (i.e. increasing the likelihood of success but decreasing the terminal balance or vice versa). They also require assumptions about future returns, interest rates, tax rates, changes to Social Security, and lifespan. All of these variables are unknowable.
The impacts of second homes are not nearly so subtle. The first time I had this discussion with clients, I was nervous to present it. They expressed their desire to keep their current home and snowbird in the winter in a condo they owned. I presented several options they could consider to improve their financial projections including working a few years longer, working part-time in retirement, cutting spending in multiple areas, or various combinations of the above.
Then, I showed the considerable impact of one action…. selling either of their properties. I was greeted by complete silence.
Finally, after a few moments, I asked what they were feeling. Disappointment? Sadness? Without hesitation, the client responded with a big smile. “Sorry, I was Googling realtors!”
Since then, I’ve gained confidence in presenting this option to clients. They often don’t appreciate the magnitude of this financial decision and feel relief understanding that one action can transform their prospects.
Visualizing the Impact
Below is a screenshot of an example showing the impact of purchasing a second home a retired client is considering. The Current Plan (right) shows how things currently stand. The Proposed Plan (left) shows the outcome of changing just that one variable: buying the second home.
The next screenshot (below) demonstrates another scenario. In this case, the client owns a vacation home (represented in the current plan on the right). The proposed plan (left) shows the impact of changing just one variable: selling it.
Opportunity Costs of a Second Home
As a financial planner, I don’t put my values on other people’s decisions. If a client truly wants a second home and is making an informed decision, more power to them.
Having a higher probability of success or dying with more money isn’t necessarily better. Conversely, a lower chance of success or lesser median ending balance isn’t necessarily worse.
Related: Defining Retirement Success and Failure
However, after meeting with clients I can get a good sense of their values. Financial planning software is impactful in demonstrating the opportunity costs of decisions when there are competing goals.
For example, in the second scenario above, I changed another variable in the software. The proposed plan below shows the impact of selling the second home and adding an additional $3,000 spend every month for approximately 20 years until reaching their anticipated retirement date. The chance of retirement success and terminal balance are virtually identical.
What other financial goals could you fund with that amount of resources? Financial planning software helps quantify the true costs of different financial decisions, particularly when you see this magnitude of impact.
Manipulating one variable at a time to see the impact of different options and help guide better decision-making is one of the best uses of a good financial calculator in my opinion.
Benefits of Second Home Ownership
With any financial decision, you also have to assess the benefits. The primary benefit of home ownership is not financial. It is enjoying the use of the property. In the right situation, a second home can certainly justify the costs.
In my mind, the ideal scenario for a second home is one that is close enough to where you live that you’ll use it often, but far enough away that it makes more sense to use it rather than just go home at the end of the day. It also makes more sense if it displaces current travel costs for those who value having a familiar place over novelty.
However, in conversations with clients, I’ve repeatedly found second homes tend to be overly romanticized. In reality, they often sit empty. People still have other travel goals (and expenses). Realistically consider how much use and enjoyment you will get from owning, or are getting if you already own, a second home.
The financial benefits and opportunities you get owning a second home are similar to those of a primary residence. However, there are financial considerations to be aware of.
There is an exclusion of gains up to $250,000 for single filers and $500,000 for taxpayers who are married and filing jointly when selling a home. However, this requires meeting ownership and use tests. Selling a second home may be less tax advantageous than selling a primary home.
Related: Will I Owe Taxes When I Sell My Home?
You can deduct mortgage interest on a second home. However, there is a limit of $750,000 of debt which qualifies. With two homes at current prices, not all of your interest may qualify for the deduction.
Risks of Home Ownership
Traditionally, risks of property damage or loss were easy and relatively affordable to insure with casualty insurance. This is no longer the case.
Extreme weather events have drastically driven up home insurance costs across the country in recent years. In some areas, insurance is becoming so expensive that some homeowners forego this cost and self-insure.
Consider the cost of insurance or the potential impact on your financial plan if you choose to forgo insurance on such a large asset and suffer a major loss.
Also, consider the potential increased liability risk that comes with owning an additional property. Don’t forget to have appropriate liability insurance coverage.
Making Informed Decisions
Summing up, the purpose of money is to create a fulfilling life lived per your values. A second home can provide a place to create memories. This can be an excellent decision depending on your situation.
However, owning any home utilizes a lot of resources. Homes tie up capital and create ongoing expenses. They demand time and/or money for maintenance and repairs. Second homes create substantial opportunity costs and add considerable risk to a financial plan, often with far less benefit than is derived from a primary residence.
Run the numbers. Understand the financial impact of this decision. Often the benefits associated don’t justify the cost and risk.
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Valuable Resources
- The Best Retirement Calculators can help you perform detailed retirement simulations including modeling withdrawal strategies, federal and state income taxes, healthcare expenses, and more. Can I Retire Yet? partners with two of the best.
- Monitor Your Investment Portfolio
- Sign up for a free Empower account to gain access to track your asset allocation, investment performance, individual account balances, net worth, cash flow, and investment expenses.
- Our Books
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[Chris Mamula used principles of traditional retirement planning, combined with creative lifestyle design, to retire from a career as a physical therapist at age 41. After poor experiences with the financial industry early in his professional life, he educated himself on investing and tax planning. After achieving financial independence, Chris began writing about wealth building, DIY investing, financial planning, early retirement, and lifestyle design at Can I Retire Yet? He is also the primary author of the book Choose FI: Your Blueprint to Financial Independence. Chris also does financial planning with individuals and couples at Abundo Wealth, a low-cost, advice-only financial planning firm with the mission of making quality financial advice available to populations for whom it was previously inaccessible. Chris has been featured on MarketWatch, Morningstar, U.S. News & World Report, and Business Insider. He has spoken at events including the Bogleheads and the American Institute of Certified Public Accountants annual conferences. Blog inquiries can be sent to chris@caniretireyet.com. Financial planning inquiries can be sent to chris@abundowealth.com]
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