The modern real estate market is often seen as a reliable and resilient investment option. With house prices steadily rising year after year, investing in property makes for a safe alternative to purchasing stocks and shares, and can provide a more rewarding return than a savings account. The attractiveness of investing heavily in property has made it the favoured portfolio addition of many middle-aged savers.
However, purchasing any property isn’t cheap, and any buy to let investor is likely to need substantial funding in the form of a buy to let mortgage. These loans differ substantially from residential mortgages, and have very different requirements which must be met. Investors who are looking to add real estate to their portfolio need to make sure they understand the requirements associated with taking out a buy to let mortgage, and appreciate how this will affect their income from the property.
Why Buy to Let?
Given the “hands-off” nature of many investment options, buying to let might seem like a strange choice. Since many investment options require little to no management, whilst becoming a landlord might entail significant work, it might seem as though letting a property is more hassle than it’s worth. However, buy to let properties present a range of benefits which other investments can’t match.
Benefits of Buy to Let Properties
Unlike with savings or stocks, where the value of your investment is directly tied to factors beyond your control, a private landlord has a degree of power in determining how their investment is managed. They can set rents, market the property as they choose, and decide how the property will be furnished, allowing them to control their earnings.
- Equity Option:
Depending on the type of mortgage they choose, a landlord may be slowly building up equity in their rental property over time, paying for it with the proceeds of their rental earnings. This means that eventually, once the loan is repaid, they fully own the property themselves – ideal if they need a retirement home, or if they plan to sell and buy somewhere else. Alternatively, landlords can often choose an “interest-only” mortgage, which allows them to minimise mortgage costs at the expense of foregoing any equity in the property.
- Safe Investment:
Property is always seen as a safe investment, because it’s a tangible, concrete asset. Unless the landlord is over-borrowing and unable to keep up mortgage payments they’ll still remain in possession of their property, whereas a stock investment can easily lose value and become worthless. Property prices have also risen consistently for many years, and though house prices do fluctuate from year to year, the general upward trend of property value means that for those who can afford to wait, real estate is a near-guaranteed positive return.
- Flexible Involvement:
Landlords can be as closely involved with a property as they want to be. That’s not to say that they should be visiting the property every day to check on their investment; this violates their tenant’s right to quiet enjoyment of the property, but landlords don’t have to do everything themselves. Although managing a buy to let property doesn’t have to take up a lot of you time, some investors might prefer to hire a property management service to act on their behalf instead. These companies will handle all the day to day running of the property, leaving you free to continue your career or enjoy retirement; however, they come at a cost, and a property management service will eat into your rental income.
It isn’t hard to see why many investors see buy to let as a sensible option; it’s relatively reliable and can either be used to turn a decent profit or build equity in a home. The attractiveness of buy to let as an investment option has driven its popularity to increase substantially in recent years, and as a result demand for mortgages to finance these purchases has also increased.
Buy to Let Mortgages – The Basics
Anyone who sets up as a landlord is going into business, which means that their applications for loans will be treated as business finance by their bank. Commercial loans are made under very different sets of rules to residential mortgages, and the stringent rules which apply for most providers make applying for a buy to let mortgage more costly and harder to comply with. This is due to the nature of the investment being made; banks see tenants as less reliable than owner/occupiers, who will usually live in the property for many years. Banks need to offset this additional risk by charging higher rates, and minimising their exposure to default by requiring better guarantees than they do from residential mortgages.
Buy to Let Deposits
The first thing any buyer will notice about the deposits for buy to let mortgages is that they are much larger; few buy to let mortgages are available with a deposit of less than 20%, compared to residential loans which can in some cases be arranged with deposits of only 5%. This is because the mortgage provider needs to ensure that it can recoup its investment should the borrower default on their mortgage payments; the more of the property the bank already owns, the harder it will be for them to make their money back.
This affects who can purchase a buy to let property, and makes it a difficult prospect for first time buyers who will struggle to come up with a deposit of this size. This requirement to put down a large percentage of the house’s value means that most prospective landlords will need significant savings of their own, often built up over several decades of saving. Many buy to let investors are in fact already property owners purchasing a second home as a safe investment, and not professional landlords looking to expand their real estate portfolio.
All lenders will differ in their requirements, but they will all need to see some evidence that the landlord will be able to reliably meet repayments of their loan, and not be susceptible to defaults. There are two components to this requirement; the earnings they expect to make from their rental property, and the earnings they already make. Most mortgage providers need evidence that proves the borrower will be able to make 125% or more of their annual mortgage costs through rental income alone – something they should be able to do if the mortgage is appropriate for them. This is because a rental property only earns money when it’s tenanted, and most landlords find that there are often “void periods” between tenants, when the property stands vacant.
In addition to this, the landlord must demonstrate that they have a reasonable income of their own, usually in excess of £25,000, to show that they themselves aren’t at risk of falling into debt. This demonstrates that they’re not utterly reliant on the property’s rental income to make ends meet, and makes them a safer bet in the mortgage provider’s eyes.
Buy to Let Arrangement Fees
Buy to let mortgages are often significantly more expensive to arrange than a residential mortgage. This is partially because banks are covering the risks they’re taking on with the loan, and partly because a buy to let mortgage is more complicated to arrange. In addition, the high demand for buy to let mortgages means that the high prices a bank may charge still won’t put off investors; the attraction of a buy to let investment is still enough that they’re undeterred by high arrangement fees.
Some arrangement fees are charged at a flat rate, but others are a percentage which scales with the cost of the property; some can cost up to 3.5% of the property value (or £9,500 on a £300,000 home). For this reason, as well as the large deposit required, buy to let property is often restricted to those with access to significant savings.
Buy to Let Mortgage Interest Rates
The upfront costs of arranging a buy to let mortgage can be high, as we’ve seen, but banks will also often charge a higher interest rate to landlords as well. Because the property is to be used as a business investment, banks are able to charge a much higher rate than they otherwise would, because the property will be earning money, unlike with a residential home. The high costs of maintaining a buy to let mortgage make it crucial for landlords to find a property which will prove profitable, and can incentivise landlords to find bargain properties or opportunities to refurbish one.
Landlords are able to offset the costs of their mortgage against the tax they pay during the year, and can use their mortgage payments to reduce the size of their tax bill. This makes the higher interest rates on BTL mortgages more acceptable to landlords, though the UK government has reduced the extent to which landlords can minimise their tax bills in this way.
Starting out as a landlord is a very viable career choice, but taking on the burden of paying for a high value buy to let mortgage is very hard to do at a young age. Most mortgage providers require that their borrowers be at least 25 years old – this is not to say that younger landlords cannot be effective, responsible and profitable, but that their names shouldn’t be the ones on the dotted line. Banks are keen to ensure that they take on as little risk as possible, so their buy to let mortgages are rarely available to anyone who isn’t a mature adult. That said, there are specialist mortgage providers who will be able to finance specialist cases not covered by mainstream lenders, but they will usually charge a correspondingly higher price for their services.
Types of Buy to Let Mortgage
As with a residential mortgage, there are several different types of payment plan on offer to landlords. The terms of these mortgages differ in that they typically require a much higher investment from the buyer, and the interest rates associated with the different types of loan are also substantially increased. However, the main difference which investors will need to be aware of is the type of repayment plan they’re signed up to, and whether they’re on a repayment mortgage or an interest-only mortgage.
A repayment mortgage is the most common type of residential mortgage available. It gets its name because the borrower repays the initial loan throughout the course of the mortgage, by the end of the mortgage term, they will have repaid the entire loan and will own 100% of the property. For owner-occupiers this is a clear bonus; the freedom to do whatever you want with your property, and the lack of any mortgage to pay, opens up many options for saving and investment. However, the need to repay both the interest on the loan along with the loan itself makes the borrower’s monthly payments higher than they would otherwise be.
This type of mortgage is more common within the buy to let mortgage market, but is now almost unknown in the residential sector. The terms of this loan allow the borrower to repay only the interest on their mortgage, which lets them keep their monthly payments that much lower. However, because they aren’t contributing to the cost of repaying the loan, they aren’t building up any ownership in the property, which means that when the mortgage term expires the full amount of the loan will need repaying.
There are several advantages to this for landlords. Firstly, reducing the monthly cost of the mortgage makes the property’s rental income that much more profitable. Since the cost of owning the property is much lower, the landlord is able to make a larger profit on the income they receive from their tenants, and contribute that to their savings or re-invest it.
Secondly, the landlord will get the option to buy the property outright at the end of the mortgage; if they’ve accrued enough savings by this time, or have sold the property they live in themselves, they can simply pay off the mortgage and take on full ownership of the rental property. This is particularly useful for couples who intend to retire into their buy to let property: they can purchase a small cottage to rent out, and contribute the money they earn from this into their savings. Once the mortgage expires they can sell their own home and move into the cottage, still with the savings they’ve earned from the rental property and any money left over from selling their home.
Finally, as mentioned before, house prices are generally buoyant, and if the property’s value increases during the course of the mortgage the landlord stands to make a profit on the sale. For example, if they take out a £100,000 mortgage on their £200,000 property and rent it out for 10 years, they will still only need to repay the £100,000 loan even if the property is worth £250,000 by that point. Though they’ll still have to pay off the full amount of the mortgage in one go, they still stand to make a profit – but only if house prices have increased.
Changes to Buy to Let Law in the UK
The attractiveness of buy to let property as an investment option has driven fierce competition in the real estate market. As we’ve seen, buy to let investors must be in a very financially sound position in order to consider buying a second property, and these buyers are increasingly coming into competition with first time buyers. The ability of buy to let investors to outbid first time buyers has led the UK government to introduce some regulations which limit how attractive buy to let investment is.
Stamp Duty Increase
Buy to let investors are now liable to an additional 3% flat stamp duty charge whenever they buy a property. Unlike with regular stamp duty, which is “stepped” according to the property value, this 3% is charged on the entire property’s value, so a £300,000 property would cost an additional £9,000 in stamp duty on top of the regular stamp duty charge.
Reduction in Tax Offsets
As mentioned previously, landlords are able to offset their mortgage payments against the tax they pay on rent, because their mortgages were seen as a business expense. New UK regulations mean that landlords can only offset a portion of their tax income in this way, which in many cases means that landlords will see their tax bills rise substantially.
More Stringent Lending Criteria
The requirements for lenders funding buy to let mortgages is also set to become more stringent, with lenders generally requiring borrowers to have a higher level of financial stability.
Is Buy to Let Right For Me?
Despite these recent changes, buy to let property is still a resilient area of the real estate market. The perception that buy to let investment is still a safer and more rewarding alternative to traditional investment is widely held, and only time will tell how the market performs in the long run.
Official resources about UK financial regulation:
- Bank of England Website
- Prudential Regulation Authority
- Financial Conduct Authority
- The Financial Policy Committee
- Financial Services Compensation Scheme
Other Unofficial Guides
Covering areas of UK financial regulation and mortgage lenders.
- Foreign Currency Mortgage
- Help To Buy Mortgage
- Hotel Mortgage
- Listed Buildings Insurance
- Million Plus Mortgage
- Short Lease Mortgage
- The Bank of England
Research provided by Falbros