A reader recently wrote:
My wife and I are considering buying a vacation home in the mountains. Prices have dropped quite a bit and interest rates are rock bottom (4.75% @ 1 point!). We have prequalified for a mortgage and have the money for closing costs. We also have an equity line of credit from our primary residence at our disposal. The problem is using up most of our savings and exposing ourselves to risk. At this point , we have almost no debt and have saved the recommended 3-6 months of emergency reserves. We don’t like the idea of taking too many risks, but we know this might be the best time to buy in our peak earning years. Retirement is less than ten years away. If we wait to save even more, the market might change. We haven’t found exactly the house we want, but felt you could give us your opinion. We respect your clear-headed point of view and know you will tell it like it is. -- DC
Now, with that background, let's dig into a more complete answer to your question.
First, I agree this could be a good time to buy a vacation home. Prices are low and interest rates are very attractive. But owning a second home is about a lot more than price and interest rates. This is a very big decision that will affect your wealth position and your lifestyle well into your retirement years. So before you do anything else, you need to think through how this home will change your life. Does it fit in with everything else you want to do? Is it consistent with your core values? Will it enhance your life or allow you to do things you otherwise wouldn't be able to do? What problems could it cause?
Second, assuming you decide that a second home is consistent with the life you want to live, you need to get very clear in your mind whether this purchase is for investment, speculation, or consumption.
Some people might call it an investment because they expect it will appreciate in value over time. But hoping for future price changes is a speculative reason to buy, not an investment reason. The distinction between the two is vital to understand.
A real estate investment generates enough cash flow through rents and tax benefits to give you an adequate return on your capital. It is like a wealth machine.
A speculation, on the other hand, relies on the hope that someone in the future will be willing to pay more than you did for your property. With speculation, your entire return depends on the fulfillment of that hope. See the difference?
If this is an investment, you need to understand how you are going to use it as an investment. Where will the cash flow come from to support the investment? Will you rent it out for part of the vacation season? Will you need a property manager? Can you get enough rental income to cover your expenses?
If its not an investment, you need to be clear on whether it is a speculative purchase or consumption. I find that many people who buy vacation homes try to rationalize them as investments (or speculations) when the purchase is really mostly about consumption. Consumption expenditures support lifestyles; investments support wealth creation.
Whether it is investment,speculation or consumption, you need to look carefully at how much the house is really going to cost. The mortgage P&I is only the tip of the iceberg. You should look at the cost of insurance, tax, travel, maintenance, furnishing, etc. Some of these costs are one-time, up-front costs and some will be with you on an ongoing basis.
Once you geta clear view of the costs, think it through carefully and make sure youreally want to incur them. The costs of furnishing and equipping your home will directly reduce your wealth. You will probably never be able to recover them.
The ongoing costs of operating and maintaining the new home will be with you for as long as you own the home no matter what else happens in your life. This is the part kills it for me. Given the uncertainty in life—especially with your desire to retire—why would you want to saddle yourself with that fixed burden? When you retire you will be on a fixed income. Most people on a fixed income benefit by keeping as much flexibility on the spending side of their ledger as possible which is why it is best to be as debt-free as possible by the time you retire.
On a more personal level, I like the fact that you are almost debt-free and that you have 6 months of liquid assets as an emergency buffer. Why would you want to put yourself into indentured servitude (that's what debt is) for a vacation home in the mountains? Will it meaningfully improve the quality of your life?
Bottom line: my advice is to keep your money, keep your freedom and go to the beach.