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Buy to let property investment has changed significantly in the last decade. A combination of government tax changes and a general slowdown in the property market, means it’s no longer as profitable to own investment properties.
Many landlords have seen a sharp drop in profits. As a result, some have left the private rental sector, never to return.
Data published in February found that the number of landlords had fallen by 222k and was currently at a seven-year low. The data also revealed that on average, landlords now own more properties. It’s clear that despite the challenging conditions, professional landlords can still make a decent living from their portfolios.
One of the most important factors in buy to let profitability is finding the right property. Choose well and you are guaranteed a good rental yield. Make a bad choice and you’ll struggle to find suitable tenants. But before you start looking for properties, you need to work out how you’re going to fund the purchase.
Landlords can either purchase buy properties with cash (i.e. using money they already have) or take out a buy to let mortgage to fund the purchase.
Buy To Let Mortgages
Buy to let mortgages are different from residential mortgages. Most are interest-only, so you are not paying down the capital each month. Lenders require a higher deposit, usually a minimum of 25%, but some of the better deals are only available if you have a deposit of 40% or more. Mortgage arrangement fees are typically higher than a residential mortgage application. The mortgage is repaid when the property is sold.
As with residential mortgages, there are different products available, such as discounted variable rate mortgages and tracker deals. It’s important to shop around, whether you are looking for a new mortgage or seeking to switch from a standard variable rate product.
The amount you can borrow will depend on how much rent you can realistically charge. Lenders usually require rental income to be 125% of the monthly payment. If your mortgage payment is £500 per month, you will need a minimum of £625 in rental income. The value of the property plays a part in the decision-making process. Let’s say you have a £40k deposit – you could then borrow £60k to buy a property worth £100k. Sadly, not in London, however!
How Popular are Buy To Let Mortgages?
The 2018 English Private Landlord Survey asked landlords how they funded their rental property purchases. 55% of landlords had a mortgage. Landlords with more properties were more likely to use mortgage funding to buy rental properties.
49% of landlords who had been in the sector for three years or less had a buy to let mortgage. 58% of landlords who had been in the sector for between four and 10 years had a mortgage, and 54% of landlords who had been letting for 11 years or more used mortgage funding.
Now we’ve covered the basics, let’s take a look at the pros and cons of using mortgage funding to purchase investment properties.
The Pros
Property gearing is a common strategy used by serious investors looking to grow a larger portfolio. Instead of using your own cash to buy a property, you use the lender’s money.
For an example of how it works, imagine you have £100k in a savings account. You could use the money to buy a property outright or put down a £25k mortgage deposit on four buy to let properties worth £100k each. As we will discuss shortly, a bigger portfolio is more advantageous. Using the money to fund four mortgaged property purchases is usually more profitable than buying just one outright.
You’ll enjoy higher investment returns with a leveraged portfolio. If the property market booms over the next five years and your properties increase in value by 12%, you’ll make £48k on four properties. This would have been only £12k if you bought one property with cash.
Unless you have a significant sum of money, mortgaging means you can purchase more properties and build a larger portfolio, which adds a layer of protection from voids and market changes. The more properties you have, the less likely you are to suffer greatly from a loss of income if a tenant falls into rent arrears or the property remains empty.
The Cons
Mortgage interest relief is no longer available, so your expenses will be higher and it’s therefore harder to make a profit. Landlords can no longer add mortgage interest tax relief to their letting expenses and will instead only be able to claim a 20% tax credit. A higher gross income pushes some individuals into a higher tax bracket, which could make buy to let a loss-making venture. For this reason, always do the math before you apply for a buy to let mortgage.
It’s not easy to get a buy to let mortgage, as lenders will look at a number of factors, including your age and your credit history. Lenders also expect you to already own a home, whether with an existing residential mortgage or outright. In addition, lenders expect you to have a minimum income of £25k a year; earning less than this will make it harder to find a lender willing to lend to you. Finally, older landlords are going to find it difficult, as there are upper age limits on how old you can be when the mortgage ends, typically 70-75.
New lending restrictions introduced in 2017 mean lenders now have to ‘stress test’ mortgage applications. This will ensure borrowers can meet their repayment obligations if interest rates rise. This makes it harder for landlords to secure mortgage funding. You can read more about this here.
It’s sensible to work with a broker if you want a buy to let mortgage, as they have access to products not available directly to the consumer. They can also make sure your application goes through smoothly and you don’t apply for mortgages you are not eligible for.
Interest rates can go up as well as down. Right now, interest rates are very low, but there is no guarantee they will stay this way. Considering the economic turmoil we are currently experiencing, taking on debt is looking less attractive by the minute.
Many buy to let mortgage products come with strings. For example, it’s common for lenders to specify what type of tenants you can’t let to, such as people on benefits or family members. You won’t be able to move back into the property if circumstances change, as this would be a breach of the terms of your mortgage.
Borrowing money is always a risk, and the more leveraged you are, the higher the risk. Don’t underestimate the risk involved in taking on a significant property debt. If life happens and you can’t meet your repayment obligations, things will unravel very quickly. A year ago, nobody could have predicted the Covid-19 catastrophe.
Even if your property income dries up, you still have to make your mortgage repayments. Make sure your cash flow can cover the mortgage repayments if you have no rental income.
You could end up in negative equity. It’s important to understand that the property market can fall as well as rise, and the more mortgage debt you have, the harder it will be to dig your way out of a hole if the worst happens. In a falling market, demand for housing plummets, and it could take months to sell a rental property. In the meantime, the lender will still expect to be paid, and if they choose, they could call in the debt and sell the property at a below market valuation. If this happens, you might still owe the lender money and have nothing to show for your debt.
The minimum deposit for a buy to let mortgage product is usually 25%. As of May, the average property price in the UK is £231,855. This means you need a minimum of £57,963 sitting in a savings account. That’s a shed load of cash!
Paying Cash
Paying cash for a property may seem like an advantageous move, but whilst it can be a good idea in some instances, it’s not always cut and dried. Let’s take a look at the pros and cons of using cash as opposed to a mortgage to fund a buy to let property purchase.
The Pros
You can snap up a property faster when you pay cash. It often takes time to finalize a mortgage application because lenders have to run checks and decide whether you are a suitable recipient for their money. It typically takes 4-6 weeks for a mortgage offer to come through, If there are any hiccups, it could take longer, which will inevitably delay the conveyancing process.
Cash buyers are more attractive to sellers because there are fewer delays. If you’re after a property with several other interested parties in the running, the fact you’re a cash buyer could sway the vendor in your favour.
It’s easier to buy a property at auction with cash. Auctions are a good place to pick up properties at below market value. Whilst it’s possible to buy an auction property with mortgage funding, you’ll need to have everything in place before you bid, and if the property is a ‘doer-upper’, don’t expect the lender to be very enthusiastic.
You’re not paying interest on a loan. Buy to let mortgages are typically interest-only, so any repayments you make are only servicing the interest accruing on the loan. This is fine as long as the property increases in value, as you’ll still make a profit when you sell. If it doesn’t, you will be in a tricky spot. Paying cash means you own the property outright as soon as you complete on the purchase.
Lenders may place restrictions on you when you purchase a property with finance. For example, you won’t usually be able to move back in. When you pay cash, you can do whatever you like, within reason.
Paying cash means you won’t lose your investment if you run into cash flow difficulties. If you can’t resolve your financial issues, all you have to do is sell the property. Even if it makes less than what you paid for it, it isn’t a disaster, as you don’t need to worry about negative equity.
Landlords paying cash for investment properties usually have smaller portfolios, which is easier to manage. This is a good thing if you are not terribly experienced.
The Cons
You need a significant sum of money to buy a property outright. It’s unlikely you have that kind of money gathering dust under the mattress.
Property is an illiquid investment and releasing the cash might take a while. Not a problem if you have all the time in the world to find a suitable buyer, but if all your spare money is tied up in bricks and mortar, what happens if you run into major cash flow difficulties? At best you will probably need to sell the property at a below market price to access your cash as quickly as possible, and at worst, your creditors might seize your asset (i.e. the property) to settle your debt.
You can’t utilise the power of leverage when you pay cash, so it’s harder to build a diverse portfolio. This is the main reason why serious investors use mortgage funding to build their portfolio.
Returns are lower with cash purchases, as we have already discussed above.
Paying cash vs. taking out a buy to let mortgage is not a straight forward decision. You need to consider all aspects, especially whether you can afford to tie up your cash or you are eligible for a landlord mortgage.
It’s a sensible idea to speak to a financial advisor or accountant before you make a final decision. The points we have covered in this article are only meant to provide some food for thought. Your financial situation is unlikely to be the same as someone else’s, so seeking personalised advice is sensible.
Let us know if you use mortgage funding to build your portfolio, or you are strictly cash only. You can reach out to us on Facebook or Twitter. As always, we love to hear from our readers, so please do get in touch!
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