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Your income doesn’t have a direct impact on your credit score, but it can have indirect effects. A loss of income, a gap in cash flow, or a sudden layoff can have you feeling a financial pinch. These circumstances could hinder your ability to pay your bills, which can ding your credit. Additionally, your income can impact your ability to open a credit card or take out a loan.

Here, take a closer look at how your income and salary could affect your credit, as well as what other factors directly determine your credit score.

Does Income Affect Credit Score?

Your income does not directly affect your credit. That’s because the financial information that’s found on your credit report is primarily related to debt. As such, information like savings or checking account balances, investments, and income do not appear on your credit report.

Beyond that, there is quite a bit of information that a credit report explicitly cannot include. These exclusions are made in an effort to prevent lenders from potentially being biased or discriminating based on race, religious affiliation, and other personal details. The following information — including income — is not included on credit reports:

•   Income

•   Employment status

•   Marital status

•   Religious affiliation

•   Race or ethnicity

Recommended: How Having a Savings Account Affects Your Credit Score

What Then Impacts Your Credit Score?

While income doesn’t affect your credit score, what does impact your score has to do with your ability to be responsible with credit. Different credit scoring models vary slightly in the way they calculate credit scores. However, they generally look for signs of creditworthiness, which is your reliability in paying back money based on past behavior and financial habits.

Here’s a closer look at what affects your credit score.

Payment History

Payment history makes up the lion’s share of your FICO® Score, accounting for 35% of your credit score. Making timely payments on your bills and debt, such as your credit card balances, car loan, or personal loan, is crucial to establishing credit.

For this reason, understanding when credit card payments are due and meeting those deadlines is an important financial habit.

Credit Utilization

Your credit usage, or credit utilization ratio, can impact your credit score significantly as well. Specifically, this makes up 30% of your FICO Score.

Your credit usage is your total outstanding balance among all your credit cards against your total credit limit. This is expressed as a percentage. For instance, if you have a $500 credit card balance, and the total limit on all of your cards is $5,000, then your credit usage is 10%.

You’ll want to aim to keep your credit utilization ratio under 30%, preferably closer to 10%. Credit usage over 30% can negatively impact your credit, as it indicates to lenders that you might be stretched too thin financially.

Age of Accounts

How long you’ve had and managed debt also impacts your credit score. This makes up 15% of your FICO Score. Keeping your old lines of credit open can help build your score by extending the age of your credit accounts.

Credit Mix

Having a healthy mix of different types of credit — think installment loans like a car or personal loan, a mortgage, credit cards, and other accounts — can also help with building credit. Your credit mix makes up a smaller portion of our FICO Score at 10%.

New Credit

If you’ve recently opened several new lines of credits or had a bunch of different hard vs. soft credit pulls from applying for credit, this could negatively impact your credit. This is because it can suggest to lenders you’re in need of funds and thus a potentially higher risk. New credit accounts for 10% of your FICO Score.

Recommended: Does Applying For a Credit Card Hurt Your Credit Score?

How Your Income Can Indirectly Affect Your Credit Score

While income doesn’t have a direct impact on your credit score, it can still affect your score in a couple of ways.

•  First, if you’re tight on money due to a recent job loss, reduced hours at your work, or a gap in cash flow, your reduced income could impact your ability to stay on top of your debt payments. As payment history makes up 35% of your FICO score, falling behind or missing payments altogether could result in your credit score taking a hit. In turn, a regular paycheck can help build your credit score because it can help you to more easily make on-time payments.

•  Your income can also impact your credit score because income is something that lenders typically look at when you apply for a line of credit. Because your income can affect your odds of getting approved for a loan or credit card, it can indirectly impact your credit mix and length of credit, which both play into your credit score.

Recommended: Difference Between Income and Net Worth

How Your Income and Debt Impact Credit Approval

When lenders evaluate your application, one factor they may consider is your debt-to-income ratio, which is the percentage of your monthly income that goes toward paying down debts. The lower your income, the more easily you can have a higher debt-to-income ratio, which could affect your odds of approval.

Additionally, when you apply for a loan or credit card, lenders will typically request proof of income, such as a paystub or a tax return. Having a low income could affect your odds of approval, as well as the amount of the loan or credit limit you’re approved for.

Recommended: Understanding Different Types of Credit Cards

The Takeaway

While the size of your paycheck doesn’t directly affect your credit score, it can impact your ability to stay on top of your debt payments. This in turn can influence your score. Understanding exactly what financial factors do impact your credit can help you to be mindful of financial behaviors and patterns that will keep your score in tip-top shape.

Whether you're looking to build credit, apply for a new credit card, or save money with the cards you have, it's important to understand the options that are best for you. Learn more about credit cards by exploring this credit card guide.

FAQ

How much does your debt-to-income ratio affect your credit score?

While your debt-to-income ratio doesn’t directly impact your credit score, it can affect your odds of getting approved for credit. If your debt-to-income ratio is too high, it’s a sign that you might be stretched thin moneywise. In turn, lenders might be less likely to extend credit to you.

Why do credit cards ask for income on applications?

Credit card issuers request your income on applications to gauge whether to extend you credit and to determine how much of a credit limit to offer you.

How much annual income do you need to be approved for a credit card?

While there’s no set number and credit card companies rarely post whether they have a minimum annual income requirement, they do take into account your income when looking over your application. Note that your annual income isn’t the only factor that credit card issuers look at when determining whether to approve your application though. Other factors like your debt load and credit score are also taken into account.

Will my income show up on my credit card?

Your income will not show up on your credit card, nor will it show up on your credit report. Personal information such as income isn’t permitted on your credit report to avoid the possibility for discrimination or bias.

How does my income affect my credit limit?

If you have a higher income, you could get approved for a higher line of credit. This is because you’ll have more available funds to pay off any debt you incur.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

This content is provided for informational and educational purposes only and should not be construed as financial advice.

Third Party Trademarks: Certified Financial Planner Board of Standards Inc. (CFP Board) owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER®, CFP® (with plaque design), and CFP® (with flame design) in the U.S., which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements.

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SOCC-Q424-002

If you have a credit card with purchase protection, you may be able to replace an item you paid for with your card should it get damaged, lost, or stolen. Among the sea of valuable credit card perks, purchase protection is one that often gets overlooked but can be a real perk.

However, there are restrictions on what is and isn’t covered under credit card purchase protection, which is why it’s important to understand how it works. You’ll also want to know the pros and cons of credit card purchase protection to determine if it’s the right path for you.

What Is Credit Card Purchase Protection?

Also known as purchase insurance or damage protection, credit card purchase protection is a type of credit card protection. If you have a purchase protection credit card, the credit card issuer might help you replace a stolen, lost, or damaged item that you bought using the card.

Purchase protection doesn’t last forever though — there are generally limits on the duration of the protection period and the coverage amounts. Also note that purchase protection serves as secondary coverage. This means that you must first file a claim with your primary insurance, and then purchase protection may kick in to cover any remaining amount.

Recommended: Does Applying For a Credit Card Hurt Your Credit Score?

How Does Credit Card Purchase Protection Work?

As mentioned, purchase protection only applies to items that you paid for with your credit card. Not all instances of theft or damage are covered.

The protection period offered by cards with purchase protection can last anywhere from 90 to 120 days after the purchase is made. Coverage limits and terms also can vary. For instance, a credit card might have $500 cap per claim, with a maximum benefit of $50,000 per account.

Some card issuers extend this credit card advantage to recipients of gifts that you purchased using the card. For instance, if you bought a computer for your son for his birthday, he may be able to file a claim to get it replaced if it’s covered by purchase protection.

Understanding How to Use Credit Card Purchase Protection

If, for example, the screen on the cell phone you purchased with your credit card shatters, and the incident occurs within your credit card’s purchase protection time frame, you may be able to take advantage of purchase protection. As noted above, purchase protection is typically secondary, which means that if you have primary insurance to cover the item, you must apply there first.

That said, to get coverage, you’d need to file a claim with the credit card. The claim form is usually found on a credit card’s website or listed under “forms” after you log in to your account. If your claim is approved, it typically takes anywhere from 5 to 30 days for you to receive reimbursement for your claim.

What Does a Credit Card’s Purchase Protection Not Cover?

Here’s what credit card purchase protection typically doesn’t cover:

•   Items that are excluded under the policy. Each card issuer has varying items that are excluded from coverage. For example, credit card purchase protection may exclude motorized vehicles, perishable items, antique or collectible items, computer software, and items purchased commercially for resale. There are also usually exclusions on the reasons for why you lost or damaged an item — for instance, items that were lost or damaged due to acts of war or fraudulent or illegal activity aren’t usually covered.

•   Items that mysteriously disappeared. If an object ends up missing with no apparent cause and without evidence of a wrongful act, then that item generally will not be covered by purchase protection.

•   Items damaged, lost, or stolen after the protection period. If an item you bought with your credit card was lost, damaged, or stolen after the coverage time window ended — usually past 90 to 120 days — then it won’t be covered.

•   Items that are used or pre-owned. Many credit card issuers exclude used or pre-owned items from purchase protection coverage.

What Does a Credit Card’s Purchase Protection Cover?

As discussed, the terms, items included, and coverage amounts provided vary by credit card issuer. For the most part, a credit card’s purchase protection covers items that were unintentionally lost, stolen, or damaged within a specified protection period.

You’ll also want to mind the cap per claim and per account. Your coverage limits may apply by account or by year. For example, you might have a cap of $500 or $1,000 per claim, and be limited to making $50,000 in claims per account you own.

Read your credit card’s terms and conditions to see what exactly is included under purchase protection and what coverage limits apply. This can also provide other valuable information to credit card holders, such as how credit card payments work.

Recommended: When Are Credit Card Payments Due?

Pros and Cons of Credit Card Purchase Protection

Here’s an overview of the advantages and disadvantages of credit card purchase protection:

Pros

Here’s a closer look at the upsides of credit card purchase insurance:

•   Built-in protection with your card. Probably the most significant advantage of credit card purchase protection is that it is essentially free insurance that comes with your card. As long as an item is covered under your card’s purchase policy, and you file a claim without the protection period, you typically can get some help replacing a lost, damaged, or stolen item, rather than driving up your credit card balance covering the cost.

•   No deductible. Unlike primary insurance, you might not need to pay a deductible to get your eligible claim reimbursed.

Cons

Here are the downsides of purchase protection to be aware of:

•   Limits. As insurance usually goes, there are coverage caps per claim and per account or year. You’ll need to check with your credit card issuer to determine the limits for your purchase protection policy.

•   May take longer than primary insurance. The time to file a claim and get reimbursed could take longer compared to the turnaround for primary insurance. That’s because purchase protection is secondary coverage, meaning you’ll usually have to go through your primary insurance first, whether that’s homeowners, auto, or rental insurance.

Recommended: What Is the Average Credit Card Limit?

Filing a Credit Card Purchase Protection Claim

Here are the steps you’ll need to take to file a claim for purchase protection:

1.    Review your card’s policies to see if the item is covered. Before moving forward with filing a credit card purchase protection claim, it’s smart to take a moment to make sure the item qualifies. Also remember that you’ll need to make at least your credit card minimum payment, even while waiting for a response.

2.    Fill out a claim form. This is usually found on the credit card issuer’s website or through your account after you log in. It’s recommended to file a claim as soon as you can. Keep in mind that credit cards typically have a time frame in which you can file a claim after the incident, usually within 30 to 90 days.

3.    Provide requested documents. When you file your claim, you’ll generally need to provide the following documents:

◦   A copy of the credit card statement that includes proof of purchase

◦   An itemized original receipt showing the purchase

◦   A copy of your insurance claim and insurance declaration page (if you have primary insurance)

◦   A police report (if the item was stolen)

Recommended: Tips for Using a Credit Card Responsibly

Other Types of Credit Card Protection

Beyond purchase protection, there are other types of protection commonly offered through credit cards. These include:

•   Return protection: This perk allows you to return an item, even when the retailer has a no-return policy. While some cards do offer return protection, other cards have phased it out in recent years.

•   Price protection: Should you buy something and the item then drops in price within a specific period, price protection will kick in and match the lower, advertised price. Depending on the card, the time frame during which this applies might range from 30 to 60 days. You might get refunded up to a certain amount for specific types of purchases, though price protection usually has limits per item and per year.

•   Extended warranty protection: Instead of hopping on a retailer’s pricey service plan or opting for extended warranty at the checkout register, you might be able to take advantage of a credit card’s extended warranty protection. This protection matches the terms of your manufacturer’s warranty. However, it usually extends protection for up to a year, and some cards will even double the manufacturer warranty.

Beyond these protections, credit cards can offer an array of other perks, such as credit card travel insurance and credit card rental insurance, among others.

Recommended: Can You Buy Crypto With a Credit Card?

The Takeaway

Credit card purchase protection can be a valuable perk if a card offers it. The built-in insurance offered by purchase protection can save you should an item you bought with your card get lost, stolen, or damaged, provided the situation meets the eligibility criteria.

Whether you're looking to build credit, apply for a new credit card, or save money with the cards you have, it's important to understand the options that are best for you. Learn more about credit cards by exploring this credit card guide.

FAQ

Do all credit cards offer purchase protection?

Not all credit cards offer purchase protection. In fact, cards offering this perk have become less common in recent years.

How do you get your money back from a credit card purchase?

You’ll need to file a claim and provide requested documents, such as a receipt, a copy of your credit card statement, and in some instances, a police report or proof of primary insurance. Once your claim has been approved, you can expect reimbursement within 5 to 30 days.

Is there a time limit on credit card purchase protection?

Yes, there’s a time window after you’ve made the purchase during which purchase protection applies. This is usually 90 to 120 days. There’s also a time limit as to when you can file a claim after the incident, which can be anywhere from 30 to 90 days. It’s best to file a claim as soon as possible.

Photo credit: iStock/filadendron

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

This content is provided for informational and educational purposes only and should not be construed as financial advice.

SOCC-Q424-024

For many homeowners who need cash in short order, a second mortgage in the form of a home equity loan or home equity line of credit is a go-to answer. A second mortgage can help you fund everything from home improvements to credit card debt payoff, and for some, a HELOC serves as a security blanket.

You can probably think of many things you could use a home equity loan or HELOC for, especially when the rate and terms may be more attractive than those of a cash-out refinance or personal loan.

Just know that you’ll need to have sufficient equity in your home to pull off a second mortgage.

What Is a Second Mortgage?

A second mortgage is one typically taken out after your first mortgage. Less commonly, a first and second mortgage may be taken out at the same time in the form of a “piggyback loan.”

Your house serves as collateral.

An “open-end” second mortgage is a revolving line of credit that allows you to withdraw money and pay it back as needed, up to an approved limit, over time.

A “closed-end” second mortgage is a loan disbursed in a lump sum.

It’s not called a second mortgage just because you probably took it out in that order. The term also refers to the fact that if you can’t make your mortgage payments and your home is sold as a result, the proceeds will go toward paying off your first home mortgage loan and then toward any second mortgage and other liens (if anything is left).

How Does a Second Mortgage Work?

A home equity line of credit (HELOC) and a home equity loan, the two main types of second mortgages, work differently but have a shared purpose: to allow homeowners to borrow against their home equity without having to refinance their first mortgage.

Rates

HELOCs may have lower starting interest rates than home equity loans, although HELOC rates are usually variable — fluctuating over time.

Home equity loans have fixed interest rates.

In general, the choice between a fixed- vs variable-rate loan has no one universal winner.

Costs

Home equity loans and HELOCs come with closing costs and fees of about 2% to 5% of the loan amount, but if you do your research, you may be able to find a lender that will waive some or all of the closing costs.

Some lenders offer a “no-closing-cost HELOC,” but it will usually come with a higher interest rate.

Example of a Second Mortgage

Let’s say you buy a house for $400,000. You make a 20% down payment of $80,000 and borrow $320,000. Over time you whittle the balance to $250,000.

You apply for a second mortgage. A new appraisal puts the value of the home at $525,000.

The current market value of your home, minus anything owed, is your home equity. In this case, it’s $275,000.

So how much home equity can you tap? Often 85%, although some lenders allow more.

Assuming borrowing 85% of your equity, that could give you a home equity loan or credit line of nearly $234,000.

After closing on your loan, the lender will file a lien against your property. This second mortgage will have separate monthly payments.

Types of Second Mortgages

To qualify for a second mortgage, in addition to seeing if you meet a certain home equity threshold, lenders may review your credit score, credit history, employment history, and debt-to-income ratio when determining your rate and loan amount.

Here are details about the two main forms of a second mortgage.

Home Equity Loan

A home equity loan is issued in a lump sum with a fixed interest rate.

Terms may range from five to 30 years.

Recommended: Exploring the Different Types of Home Equity Loans

Home Equity Line of Credit

A HELOC is a revolving line of credit with a maximum borrowing limit.

You can borrow against the credit limit as many times as you want during the draw period, which is often 10 years. The repayment period is usually 20.

Most HELOCs have a variable interest rate. They typically come with yearly and lifetime rate caps.

Second Mortgage vs Refinance: What’s the Difference?

A mortgage refinance involves taking out a home loan that replaces your existing mortgage. Equity-rich homeowners may choose a cash-out refinance, taking out a mortgage for a larger amount than the existing mortgage and receiving the difference in cash.

Taking on a second mortgage leaves your first mortgage intact. It is a separate loan.

To determine your eligibility for refinancing, lenders look at the loan-to-value ratio, in part. Most lenders favor an LTV of 80% or less. (Current loan balance / current appraised value x 100 = LTV)

Even though the rate for a refinance might be lower than that of a home equity loan or HELOC, refinancing means you’re taking out a new loan, so you face mortgage refinancing costs of 2% to 5% of the new loan amount on average.

Homeowners who have a low mortgage rate will not benefit from a mortgage refinance when the going interest rate exceeds theirs.

Pros and Cons of a Second Mortgage

Taking out a second mortgage is a big decision, and it can be helpful to know the advantages and potential downsides before diving in.

Pros of a Second Mortgage

Relatively low interest rate. A second mortgage may come with a lower interest rate than debt not secured by collateral, such as credit cards and personal loans. And if rates are on the rise, a cash-out refinance becomes less appetizing.

Access to money for a big expense. People may take out a second mortgage to get the cash needed to pay for a major expense, from home renovations to medical bills.

Mortgage insurance avoidance via piggyback. A homebuyer may take out a first and second mortgage simultaneously to avoid having to pay private mortgage insurance (PMI).

People generally have to pay PMI when they buy a home and make a down payment on a conventional loan of less than 20% of the home’s value.

A piggyback loan, or second mortgage, can be issued at the same time as the initial home loan and allow a buyer to meet the 20% threshold and avoid paying PMI.

Cons of a Second Mortgage

Potential closing costs and fees. Closing costs come with a home equity loan or HELOC, but some lenders will reduce or waive them if you meet certain conditions. With a HELOC, for example, some lenders will skip closing costs if you keep the credit line open for three years. It’s a good idea to scrutinize lender offers for fees and penalties and compare the APR vs. interest rate.

Rates. Second mortgages may have higher interest rates than first mortgage loans. And the adjustable interest rate of a HELOC means the rate you start out with can increase — or decrease — over time, making payments unpredictable and possibly difficult to afford.

Risk. If your monthly payments become unaffordable, there’s a lot on the line with a second mortgage: You could lose your home.

Must qualify. Taking out a second mortgage isn’t a breeze just because you already have a mortgage. You’ll probably have to jump through similar qualifying hoops in terms of home appraisal and documentation.

Common Reasons to Get a Second Mortgage

Typical uses of second mortgages include the following:

•   Paying off high-interest credit card debt

•   Financing home improvements

•   Making a down payment on a vacation home or investment property

•   As a security measure in uncertain times

•   Funding a blow-out wedding or other big event

•   Covering college costs

Can you use the proceeds for anything? In general, yes, but each lender gets to set its own guidelines. Some lenders, for example, don’t allow second mortgage funds to be used to start a business.

The Takeaway

What’s the point of a second mortgage? A HELOC or home equity loan can provide qualifying homeowners with cash fairly quickly and at a relatively decent rate. If you prefer not to have a second mortgage, you may want to explore a cash-out refinance, which is another way to put some of your home equity to use.

Looking for an affordable option for a home mortgage loan? SoFi can help: We offer low down payments (as little as 3% - 5%*) with our competitive and flexible home mortgage loans. Plus, applying is extra convenient: It's online, with access to one-on-one help.

FAQ

Does a second mortgage hurt your credit?

Shopping for a second mortgage can cause a small dip in an applicant’s credit score, but the score will probably rebound within a year if you make on-time mortgage payments.

How much can you borrow on a second mortgage?

Most lenders will allow you to take about 85% of your home’s equity in a second mortgage. Some allow more.

How long does it take to get a second mortgage?

Applying for and obtaining a HELOC or home equity loan takes an average of two to six weeks.

What are alternatives to getting a second mortgage?

A personal loan is one alternative to a second mortgage. A cash-out refinance is another.

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Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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One of the top tax benefits available to real estate investors is depreciation, the income tax deduction that comes from spreading out the cost of a property over the time that you use it and deducting a portion of its cost each year. Cost segregation, in turn, is a tax strategy that can be used to accelerate depreciation deductions — so it’s definitely worth knowing about.

Keep reading for a look at how cost segregation in real estate works and if this often-overlooked planning tool might make sense for you.

Definition of Cost Segregation

Cost segregation is a tax planning tool used by businesses and those who invest in real estate to accelerate depreciation deductions on certain parts of their properties.

Basic Concept

Instead of using just one or two categories (or asset classes) to calculate the depreciation on a property for income tax purposes, cost segregation separates the property into multiple categories, some of which have shorter depreciation periods. This allows property owners to claim a larger portion of their depreciation deduction sooner, which can lower their tax liability and increase their cash flow. (Remember to consider the full list of possible tax strategies as an investment property owner, including offsetting rental income with deductions such as the mortgage interest deduction.)

Purpose in Real Estate Investing

For real estate investors, depreciation is typically divided into two categories: building and land. Land doesn’t depreciate for tax purposes, but buildings do. Generally, residential buildings are depreciated over a 27 1⁄2-year period, according to IRS requirements, and nonresidential buildings are depreciated over a 39-year period.

Because the depreciation period on a building is so long, the yearly deduction owners get doesn’t necessarily amount to significant savings. Though the depreciation deduction adds up over time, it can take a while for an owner to realize the tax benefit. Some owners paying for a property with a home mortgage loan may think about exploring cost segregation to capture tax benefits to counteract those monthly payments. (They may also want to read up on how to avoid capital gains taxes on real estate.)

Cost segregation analysis puts additional categories beyond land and building into the mix, which means some parts of the property (certain fixtures, site improvements, or equipment, for example) may be depreciated over a shorter period of time (typically five, seven, or 15 years). This can give owners the ability to take larger deductions sooner, which can result in substantial tax savings, potentially accelerating the return on investment and boosting the overall financial performance of the investment.

Recommended: Amortization vs. Depreciation

How Cost Segregation Works

Cost segregation analysis requires identifying and reclassifying building components into categories that have shorter depreciation periods for tax purposes. This can allow real estate investors to accelerate the depreciation deductions for these specific items and lower their tax liability earlier in their ownership of the property.

For example, plumbing fixtures, furniture, equipment, and other components that aren’t permanently attached to the building could potentially be classified as personal property and depreciated over five years instead of 27½ or 39 years. Site improvements (such as landscaping, paving, and fencing) could be classified as land improvements and depreciated over 15 years. These tighter timelines can allow an owner to take advantage of available tax breaks sooner rather than later.

Recommended: Buying a Foreclosed Home

Cost Segregation Study Process

Usually, the first step in deciding if and how to use cost segregation is to hire a financial firm (preferably one with expertise in engineering and tax law) to perform a cost segregation study on your building and its systems. What is a cost segregation study? Your team will:

•   Analyze your property to determine which components can be separated into categories with shorter depreciation periods.

•   Use documentation — such as home inspection reports, a recent property appraisal that shows how much the house is worth, closing documents from the property sale, and other relevant records — to inform and support their decision-making.

•   Prepare a report that shows you how much you might save on taxes by implementing a cost segregation strategy.

You can then use this information for tax planning and preparation purposes.

Benefits of a Cost Segregation Study

The goal of cost segregation is to reduce your tax liability so you can put that money back into your business, perhaps with improvements or by taking out another investment property mortgage. But a cost segregation study may offer other advantages, as well. Here’s a breakdown of the benefits a professional cost segregation analysis may provide:

•  Increasing tax savings by reducing the depreciation period for certain assets.

•  Increasing cash flow and improving the overall return on investment by accelerating depreciation deductions.

•  Improving asset management and offering a more accurate accounting of the property’s assets and their value.

•  Finding other potential tax credits and incentives.

•  Ensuring compliance with tax laws and IRS regulations.

Types of Properties Suitable for Cost Segregation

Cost segregation could be a useful strategy for a wide range of real estate investments. But it can be especially well-suited to properties that have specialized equipment, systems, or a significant number of other assets that could be reclassified to a shorter depreciation period, such as:

•  Commercial real estate like retail spaces, office buildings, and warehouses

•  Rental properties, including multifamily residential buildings

•  Resorts and restaurants

•  Medical facilities

When Should You Consider Cost Segregation?

Timing can be an important factor when considering a cost segregation strategy. You can order a study at any time, but it may be particularly useful if you’re the owner of a newly constructed building, a recently remodeled or renovated property, or a newly acquired property. This way you can use the information when you file your tax return and maximize the tax savings at a time when you need it most.

Cost Segregation Methods

There aren’t any established requirements for the preparation of cost segregation studies, but according to the IRS, six of the most common approaches include:

•  Detailed Engineering Approach from Actual Cost Records: Uses actual records — blueprints, specifications, contracts, job reports, and other construction documents — to determine costs.

•  Detailed Engineering Cost Estimate Approach: This is similar to the approach above, but it uses estimated instead of actual costs.

•  Survey or Letter Approach: Contractors and subcontractors are contacted to provide information on the cost of specific assets that they installed on a particular project.

•  Residual Estimation Approach: This is a shortened method for which only short-lived asset costs are determined. The total amount of these asset costs are subtracted from the total project cost.

•  Sampling or Modeling Approach: This method uses a model (or template) to analyze multiple facilities that are nearly identical in construction, appearance, and use.

•  Rule of Thumb Approach: This approach generally uses little or no documentation and is based instead on the preparer’s “experience” in a particular industry.

Working with Cost Segregation Professionals

You may find it helpful to use an online calculator to help you estimate how much you’ll save on taxes and to decide if it’s worth proceeding with a cost segregation strategy. But when it’s time to do the actual study, it’s generally not a DIY job. (According to the IRS’s Cost Segregation Audit Technique Guide, the No. 1 element of a quality study is “Preparation by An Individual with Expertise and Experience.”)

Engineering firms, tax advisory firms, construction cost consultants, and some large accounting firms often have a team of specialists that perform this type of work. Or you may be able to find a cost segregation firm that focuses exclusively on providing cost segregation studies.

Costs Associated with Cost Segregation

The price of a cost segregation study may vary significantly depending on several factors. But you can expect to pay anywhere from $5,000 to $30,000 or more based on the size of the property, the assets being analyzed, location of the property, the level of detail in the study, whether the work is done in person or remotely, and the experience and reputation of the firm doing the work. It can be helpful to do some comparison shopping and to get quotes from the firms you think could be the best fit for your goals.

Once you’ve estimated the costs involved, you can decide if the tax and other potential savings are worth the time, effort, and money that will go into a cost segregation study.

IRS Guidelines and Regulations

According to the Cost Segregation Audit Technique Guide, to meet IRS expectations, a taxpayer should submit a “quality cost segregation report” supported by a “quality cost segregation study.” The guide provides an in-depth look at what it takes to meet those expectations and the legal and legislative precedents that got us where we are today. And it stresses that taxpayers must be able to substantiate their asset classifications and depreciation deductions.

The Takeaway

Cost segregation is a complex tax deferral strategy that allows real estate investors to lower their tax bills earlier in their ownership by reclassifying certain parts of their property to shorter depreciation periods. This can help them free up money sooner for reinvestment or other purposes.

You may want to talk to a financial professional about whether cost segregation would benefit you, and how to find the right team to get the process started.

Looking for an affordable option for a home mortgage loan? SoFi can help: We offer low down payments (as little as 3% - 5%*) with our competitive and flexible home mortgage loans. Plus, applying is extra convenient: It's online, with access to one-on-one help.

FAQ

How much can I save with cost segregation?

Several factors can go into determining how much you could save with cost segregation, including the cost of your property, whether you have assets that can be reclassified to a shorter depreciation period, and how much your cost depreciation study costs.

Is cost segregation only for new properties?

A cost segregation may be more efficiently executed for a new property or one that’s been recently renovated. But by using a “look-back” study, the strategy could also be used on a property that you’ve owned for several years.

How long does a cost segregation study take?

It could take the firm you hire one to two months to complete your cost segregation study, depending on the size of your property and how helpful you can be with providing the information and documentation they require.

Photo credits: iStock/

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SoFi loans are originated by SoFi Bank, N.A., NMLS #696891 (Member FDIC). For additional product-specific legal and licensing information, see SoFi.com/legal. Equal Housing Lender.

SoFi Mortgages
Terms, conditions, and state restrictions apply. Not all products are available in all states. See SoFi.com/eligibility-criteria for more information.

*SoFi requires Private Mortgage Insurance (PMI) for conforming home loans with a loan-to-value (LTV) ratio greater than 80%. As little as 3% down payments are for qualifying first-time homebuyers only. 5% minimum applies to other borrowers. Other loan types may require different fees or insurance (e.g., VA funding fee, FHA Mortgage Insurance Premiums, etc.). Loan requirements may vary depending on your down payment amount, and minimum down payment varies by loan type.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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This article is not intended to be legal advice. Please consult an attorney for advice.

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You’ve probably used an Automated Valuation Model (AVM) without even realizing it. When you open up your favorite real estate site, type in a street address, and instantly see an estimate of what the property is worth, you can thank an AVM. This data tool, which has proliferated in recent decades, uses software, algorithms, and existing information to calculate an estimated value for a given piece of property.

AVMs may have made it easier to estimate the sale price of a house you have your eye on, but they have their limitations, too. Below, we’ll dive into how AVMs work, how they’re used — and when you might still need to rely on a human appraiser.

What Is an AVM?

Pinning down how much a home is worth is a process known as property valuation — and has historically been a job for human property appraisers. But as computers proliferated and software evolved, eventually, AVMs were created. They’ve been around for a while now: Zillow launched its Zestimate product, which functions on an AVM, in 2006. It’s now possible to get a basic understanding of what your home is worth in mere seconds.

How AVMs Work

AVMs allow big companies like Zillow — as well as lenders, real estate agents, and shoppers — to get a quick estimate of a home’s value at a glance. These software products use a matrix of existing data (more on that below) to spit out a good guess as to what a home might be worth.

AVMs are also helpful because they’re updated in real time based on ever-changing market factors. For instance, if one property on a block sells for a higher price than expected, that sale price will begin factoring into the AVMs for the other homes on the block as soon as the information is public. In other words, the information is far more dynamic and constantly up-to-date than a human appraiser could offer with a single study.

Recommended: The Home Mortgage Interest Deduction Explained

Key Components of AVMs

AVMs utilize a collection of different data sources and statistical algorithms to build their estimates. There are several different AVM companies that offer these programs to clients who use them, and they each have their own proprietary way of computing home values.

Some of the most common information that automated valuation models rely on includes:

•  Public records that can include information like property sales and tax history

•  Multiple Listing Service (MLS) data, which offers pricing information on other, similar properties (known in the industry as “comps”)

•  Information about the property, such as its age, size, and tax assessment, which may be pulled from public record

Using machine learning combined with algorithms created by the professionals coding the software, AVMs can use these pieces of information to generate an up-to-date estimate for just about any property in America — though its level of accuracy may vary.

For example, with newly constructed properties, there may not be many perfect comps available in the area, which could lead to a less accurate AVM estimate. There are other situations where AVM accuracy might be lacking, too — we’ll dig into that below.

Applications of AVMs

Automated valuation models are useful in a whole host of situations — from mortgage lending, where lenders can use the information to make better informed underwriting decisions, to portfolio management, which can help investors understand the current value of their real estate assets.

And as anyone who’s ever quickly looked up the price of an eye-catching house can attest, AVMs are very useful for property shoppers, too. As long as the estimate is treated as just that — an estimate rather than an exact price — having access to AVM information can help browsers understand which homes they can afford to make an offer on or how much financial preparation they’ll need to do to be able to afford the house of their dreams. (They won’t, however, give you a complete picture of how much it will cost to own the home. For that you need a mortgage calculator with taxes.)

Advantages and Limitations of AVMs

Like everything else in life, AVMs have both advantages and limitations to keep in mind.

Advantages of AVMs include:

•  Speed. Even the very fastest human property appraiser can’t update every property’s valuation every few hours like an AVM can.

•  Cost-effectiveness. While appraisals must be paid for on a per-appraisal basis, factoring in the appraiser’s time working and expertise, companies may pay for AVM software once or as an affordable subscription service.

•  Scalability. Since AVMs rely on algorithms, they can offer thousands of valuations based on less overall work than the bespoke human appraisal process.

On the other hand, their drawbacks include:

•  Potential for inaccuracy. Any algorithm is only as good as the data fed into it, and mistakes in public records do happen. Records can also be outdated — not reflecting an HVAC upgrade, for example.

•  Inability to assess intangibles. There are some factors (such as property condition) that can affect a home’s value that don’t easily translate to a database. In these instances, a human appraiser still has the edge.

AVM Accuracy and Reliability

As we’ve seen, although AVMs can offer a lot in terms of speed and cost-efficiency, they can sometimes lag behind human appraisers when it comes to accuracy. You might hear the phrase “AVM appraisal” but a valuation isn’t truly the same as an appraisal that you would get from a professional. Newly constructed or non-traditional properties can be more difficult to assess for value based on comps (since there aren’t many or any good ones), and intangibles like property condition don’t always show up in the data these algorithms draw from.

Fortunately, some AVMs also offer confidence scores, which can help those using the estimates to understand how likely it is that the value offered is accurate (or close to it). You could also check with a knowledgeable real estate professional to get their take on whether a given estimate hews closer or further from the truth.

Impact on the Real Estate Industry

AVMs have already changed the real estate industry by making home value estimates widely and readily available to the general public. Along with helping buyers shop in what can sometimes feel like a confounding market, AVMs also make it easier for those who do own their home to understand how much equity they’ve built — or how much they might stand to gain by selling.

While a human appraisal and home inspection continue to be common parts of most real estate transactions, over time, as they increase in accuracy, AVMs may reduce the need for such services, potentially saving money for those on the market. They could also help speed up the underwriting process for home mortgage loan lenders, as well as making it easier for real estate agents to offer their clients home showings in their price range.

The Future of AVMs

Although AI has been all the rage the last few years, we’re still just at the very beginning of this new line of technology — which has the potential to evolve at an exponential rate. While many AVMs are already incorporating machine learning and other high-tech methods, technological developments along with the continued progress of AI and big data could see these valuations becoming far more accurate and accessible over time.

Recommended: Are Property Taxes Included in Mortgage Payments?

The Takeaway

Automated valuation models, or AVMs, have already changed the real estate industry — and have the power to continue to do so as technology improves and advances. However, human appraisals still have an irreplaceable role in today’s market, ensuring the best accuracy for tax assessments and sales.

Looking for an affordable option for a home mortgage loan? SoFi can help: We offer low down payments (as little as 3% - 5%*) with our competitive and flexible home mortgage loans. Plus, applying is extra convenient: It's online, with access to one-on-one help.

FAQ

How do AVMs compare to traditional appraisals in terms of accuracy?

Generally speaking, AVMs are not as accurate as a traditional appraisal. While AVMs are both speedy and cost-effective, their estimates are only as good as the data fed into the program — and, of course, sometimes that data can be inaccurate. AVMs also often can’t evaluate property conditions and other intangible elements that a human appraiser could easily spot.

Can AVMs completely replace human appraisers?

As is true in all parts of technology, as advancements continue, the jobs those technologies make easier may change. For now, human appraisers are still an important part of the real estate market, offering their expertise and individualized focus on a property rather than relying blindly on computer algorithms and data.

How do AVMs handle unique or recently renovated properties?

Nontraditional, newly renovated, or newly constructed properties can be challenging for AVMs, since they utilize publicly available information about comparable properties, or “comps,” to make their estimates (and these types of properties may not have very good comps available). AVMs also assume the same level of condition for all homes, which means they might overvalue a home in disrepair — or undervalue a newly renovated one.

Are AVM results accepted by all financial institutions?

Because AVMs can not (yet) match the accuracy and reliability of a human appraisal, many mortgage lenders still require human appraisals to be part of the purchase process. AVMs are new enough that legislation is still actively being made to regulate their use and ensure they comply with nondiscrimination laws and avoid conflicts of interest. Over time, more lenders may allow AVMs to replace human appraisals, but that’s not the market we have today.

Photo credits: iStock/miniseries

SoFi Loan Products
SoFi loans are originated by SoFi Bank, N.A., NMLS #696891 (Member FDIC). For additional product-specific legal and licensing information, see SoFi.com/legal. Equal Housing Lender.

SoFi Mortgages
Terms, conditions, and state restrictions apply. Not all products are available in all states. See SoFi.com/eligibility-criteria for more information.

*SoFi requires Private Mortgage Insurance (PMI) for conforming home loans with a loan-to-value (LTV) ratio greater than 80%. As little as 3% down payments are for qualifying first-time homebuyers only. 5% minimum applies to other borrowers. Other loan types may require different fees or insurance (e.g., VA funding fee, FHA Mortgage Insurance Premiums, etc.). Loan requirements may vary depending on your down payment amount, and minimum down payment varies by loan type.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

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