Investment property vs second home: how do lenders tell the difference?
By how the property is used. A second home is a one-unit place you live in for part of the year, a lake cabin, a condo near family, somewhere suitable for year-round use that you don't rent out under a management agreement. An investment property is held to rent for income, whether or not you ever set foot in it.
Lenders verify the distinction with your application, the property's location and type, and supporting documentation, and they take it seriously because it changes how the loan is priced. The conventional definition of a second home, the occupancy tests and the distance and use expectations, is covered on my conventional loan guide, so I link it rather than repeat it: see the conventional second home guide.
Why does occupancy change the rate and down payment?
Because lenders price risk by how a property is used. A home you live in is the safest bet for a lender; a second home is a step riskier; an investment property is riskier still. The logic is simple: when money is tight, people protect the roof over their own head first.
So the terms step up with the risk. An investment property generally carries a higher rate and a larger down payment than a second home, which in turn costs more than a primary residence. That's also why the classification isn't a preference you pick for a better rate; it follows how you'll actually use the property. The investment-property down payment and reserve detail gets its own down payment and reserves guide.