DSCR Loans vs. Second Home (“10% Down”) Loans for STRs

Second home loans are another pathway some investors consider when financing short term rentals. Their main attraction is the low down payment requirement, as little as 10% down (this is such a draw that these loans are often also referred to as “10% Down” Loans, due to their maximum loan-to-value (LTV) ratios of 90%).  For investors who want to use leverage to the max to scale, these are obviously attractive.  Compared to the traditional 20% down payment requirement (as with DSCR Loans, which typically have 20% down as the absolute minimum), this can be an attractive differentiator to scale.

Leverage is often more multiplicative than people think, even seasoned real estate investors underestimate this.  To illustrate, 10% down vs. 20% down for an investor with $200,000 of capital means the difference of a million dollars in real estate acquisitions, where an investor with two second home loans with 10% down means they can buy two million-dollar properties ($100,000 or 10% down on each) versus just one million-dollar property with a DSCR Loan with 20% down.  This multiplies and scales over time assuming success, cash flow and capital accumulation, so it’s easy to see why scale-hungry investors home in on these loans when dreaming big.

However, it’s not so simple.  Second home loans are still conventional loans (they are a subset of loans backed by Fannie Mae), and still require all of the DTI and tax returns requirements, prohibit LLCs and still come with the same size and concentration limits that present problems with using conventional loans for short term rentals.  In addition, these loans are intended for individual borrowers’ second homes (it’s in the name), rather than for purely rental properties (like DSCR Loans are).  While these loans do allow for the owners to generate income from the properties through renting them out, this comes with lots of restrictions.  Second home loans are intended for properties that can be used for dual purposes: as a second home or vacation home that can also sometimes be rented out to cover costs.  Note that the merits of the federal government subsidizing individual’s “second homes” through guaranteed financing should be highly debatable, but that’s a topic for another day.

The Problems with using Second Home Loans for Short Term Rentals

Because these Second Home Loans are intended for, at most, dual-use as a second home and vacation rental rather than a mostly-rental property, there are lots of restrictions on usage of these properties as short term rentals when using this type of financing.  These include:

• Restrictions on Days Rented Per Year: Short term rentals financed by second home loans must be “primarily” for owner-use, generally interpreted as no more than 180 days (or half the year) rented out.  This restriction obviously takes the wind out of the sails of any serious STR investors, finding profitability on a STR with a hard ceiling of 50% occupancy is all but impossible except for the rarest of properties in very seasonal markets, or with minimizing mortgage costs with extremely low leverage (which would also defeat the primary purpose most investors would use these loans for, the 90% leverage).  Additionally, jamming all the rental activity into a few short seasonal months would also defeat the purpose of a dual-use property, as owners seeking any sort of return would need to refrain from enjoying the property themselves during the attractive months.

• Restriction on Property Management: STRs with second home loan mortgages that are rented out can be rented out via STR platforms such as airbnb or VRBO however, a third-party manager can’t be used, the individual owner must manage the property themselves, including responding to and communicating with guests and either performing necessary services like cleaning, maintenance and landscaping, or overseeing those vendors.  Scaling becomes all but impossible self-managing past a few properties, and this is another feature of second home loans that is problematic for serious short term rental investors looking to scale.

• Restriction on Unit Counts: Second Home Loans are only eligible for SFRs (single family residences), meaning these loans can’t be used for duplexes, triplexes or fourplexes or mixed in with the “house hacking” strategy that mixes some units as owner-occupied with others used as pure rentals to maximize earnings.  Another shortcut to STR scaling is to capitalize on the outsized returns of multi-unit properties, this is another door closed on investors using second home loans for STRs.

• No Vesting in LLC Allowed: The ability to own the properties in individual LLCs and borrow through the entity is not allowed under second home loans, which must be made to an individual.  This shuts out STR investors going this route from the numerous important benefits of LLCs for STRs.  Primarily, it disallows the liability protection benefits that appeal to property owners operating STRs with lots of guests, turnovers and potential problems arising from having so many people come and go from a property.  It also prevents the popular capital raising strategies for STR investors, many of whom like to split ownership to raise money for down payments, or simply to partner up with people with complementary skill sets and aptitudes.  Finally, second home loans will go directly on the individual borrower’s credit reports, instead of being held off, which can damage credit rating and capacity.

• Geographic Restrictions: While this rule is somewhat vague, geographic restrictions on second home loans cut in two directions; meaning the property has to be both far away enough from the borrower’s personal residence (i.e. in a legitimately different market) but also close enough, “a reasonable distance,” to be managed and utilized as a second home.  To illustrate, a borrower living in Austin, Texas might have trouble qualifying for a second home loan in Cape Cod, Massachusetts since it’s so far away, but also not qualify for a home on Lake Austin in nearby Lago Vista (~25 miles away) since it’s the same market, even if one property is a lake house and one is an urban townhome.

Additionally, when using a second home loan with only 10% down, borrowers must pay private mortgage insurance (PMI) which is required if the loan-to-value (LTV) ratio exceeds 80.0% (or whenever the down payment is less than 20%). PMI premiums vary based on credit score, LTV, and loan size, but a typical range is 0.3% to 1.0% of the loan amount per year. For example, on a $400,000 loan with 10% down, PMI might add $1,200–$3,000 annually ($100–$250 per month).  While PMI can eventually be canceled once equity reaches 20%, in the early years it meaningfully increases carrying costs, further eroding the limited cash flow that second home loans allow for short-term rentals.

In summary, while second home loans for STR investing and the low 10% down payment requirement may seem very enticing at first look, when you dig in, they make much less sense. Generating cash flow becomes all but impossible (especially in an environment without rock-bottom rates) considering the 50% occupancy floor (rental days restriction), one-unit max, PMI costs and monthly debt payments.  Additionally, many investors, especially those looking to scale or even those just learning the ins and outs of STR ownership are severely hindered by the restriction against using management help, the lack of the ability to operate within an LLC and the confusing geographic rules.  All in all, second home loans may represent a good option for dipping a toe into investing in short term rentals (i.e. getting first experience with a dual-use property on a family’s second home), but they are neither an intended nor scalable solution for serious STR investing.

Second home loans can look appealing because of the 10% down requirement, but usage restrictions, PMI costs, and DTI underwriting make them poorly suited for full-time STR operations. DSCR Loans, by contrast, provide the flexibility and scale professional investors need to operate year-round, use management companies and build larger portfolios.

Chart: DSCR Loans vs. Second Home (“10% Down”) Loans

Q: Can I use a DSCR Loan to finance a second home or vacation home I’ll use part-time?

A: No. DSCR Loans are strictly for investment properties and require that the home be operated 100% as a rental. If your primary intent is personal use, such as a vacation home you’ll only rent occasionally, you’ll need a conventional second home loan instead, since DSCR Loans are for business-purpose (i.e. rental) only, and generally allow only very minimal owner-use (up to 14 days per year typically on a vacation rental).

Up Next: DSCR Loans vs. DSCR Loans for Short Term Rentals (or How DSCR Lenders Differ when it comes to STR Loans)

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