Guide to buy-to-let mortgages
- Buy-to-let mortgages, from start to finish
- Mortgages, insurance, tax, property choice
- Expert advice to help kick-start your portfolio
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Are you considering becoming a landlord? For sure, there’s a lot to take in. But the rewards warrant the effort if you take advice, form a plan and stick to it.
In our buy-to-let guide, you’ll find all the advice you need to plot a successful buy-to-let strategy:
- How the products work;
- Landlord eligibility criteria;
- How much you could potentially borrow for a rental property;
- Tax implications, including Stamp Duty;
- How to set your rental expectations;
- Your responsibilities upon becoming a buy-to-let landlord;
- Advice to help you make the right decisions as queries arise.
Our detailed Table of Contents gives an insight into exactly what this guide covers:
Recent changes affecting buy-to-let landlords
Buy-to-let landlords have felt the impact of significant changes to regulation and taxation over recent years. Two key factors have come into play in quick succession:
- The introduction of an additional 3% Stamp Duty levy on investment properties (2016);
- The gradual removal of mortgage interest relief (since 2017).
Combined, these measures by HMRC have reduced the profitability of owning rental property.
The rules around buy-to-let mortgages can also be a minefield to the uninitiated. Without doubt, it’s best to seek the advice of a buy-to-let mortgage expert from the off. Speaking to a broker (like Mortgage Quest) is the easiest, safest way to get the right mortgage for your rental property.
Is buy-to-let a good investment?
Even after the recent changes, there’s still mileage in the adage, “safe as houses”. So, if you’re interested in investing and would prefer to put your money into bricks and mortar rather than stocks and shares, a buy-to-let property might be one option worth considering.
There’ll always be a market for landlords so long as there’s a shortage of affordable properties and social housing. And, despite governments from all quarters promising new housing stock, we’ve yet to see a meaningful indent in the dire shortage left by ‘Right to Buy’ in the 80s.
The recovery from the financial crisis of 2008 has seen property prices rise almost continually. And, despite ‘experts’ foretelling a market collapse, it’s not happened.
Investing in a property to rent comes with unique risks and challenges, though. In the current uncertain economic climate, landlords have to monitor and factor in rising inflation and interest rates. Therefore, you must get advice about making the figures work before you take the plunge.
What is a buy-to-let mortgage and how do they work?
You can’t buy an investment property with a normal residential mortgage. Buy-to-let mortgages and residential mortgages are different animals.
You need a specialist buy-to-let mortgage. Exactly which type will depend on your circumstances and requirements; there are buy-to-let deals for:
- first-time landlords;
- ‘accidental’ landlords;
- professional investors with large property portfolios.
Most buy-to-let mortgages are interest-only. That means the landlord pays the monthly mortgage interest using the rental income from his tenant(s). The difference between those two figures is his profit, or ‘yield’ (as a percentage).
Lenders, therefore, use different affordability criteria for residential mortgages than for buy-to-let. With residential mortgages, affordability is assessed on the customer’s personal income. With buy-to-let mortgages, lenders predominantly base their assessment criteria on the property’s potential rental income.
Also noteworthy: interest rates and deposit requirements can be higher for buy-to-let mortgages.
Getting a buy-to-let mortgage
Lenders use a rental affordability calculation to determine how much you can borrow. Although the mortgage loan assessment is weighed heavily on the rental income, if the rental income is low some lenders will also use your personal income. This method is referred to as “top-slicing”.
The rental affordability calculation is also known as the “Stress Test” or “Stress Income Cover Ratio” (SICR), which can vary between lenders. As well as varying from lender to lender, they may also vary depending on whether you’re a higher- or lower-rate taxpayer.
Higher-rate versus lower-rate taxpayer income expectation differences
Since 2017, changes introduced by the Prudential Regulatory Authority (PRA) have meant lenders have to apply much stricter criteria for buy-to-let borrowers.
For basic rate taxpayers, lenders expect the monthly rental income to exceed at least 125% of the monthly interest payments. For the test, they use a nominal rate of around 5.5% to 6%, even if the actual mortgage rate is lower.
For higher-rate taxpayers, lenders often ask that the monthly rental income is at least equal to 145% of the monthly interest payments. They use this calculation to ensure the landlord has enough surplus income from the property to pay for repairs, non-payment of rent, service charges, etc.
It can seem a little complicated, but it’s important to understand how lenders use this stress test. Knowing in advance gives you a better idea of whether a lender will approve your application.
Example of the stress test calculations using SICR
As mentioned, the typical stress test uses a Stress Interest Cover Ratio (SICR) of around 5.5% and a Rental Cover Rate of between 125%-145%.
We’ll base the example on a mortgage loan of £300,00 with a nominal stress rate of 5.5% and rental cover at 145% (higher rate taxpayer).
Step 1: Work out the annual interest
Annual interest = loan amount (£300,000) × stress rate (5.5%) = £16,500
Step 2: Work out the minimum annual rental income
Minimal annual rental income = Annual interest (£16,500, from above) × rental cover (145%) = £23,925
This means that the minimum monthly rental income = £23,925/12 = £1,993.75.
Our buy-to-let rent calculator allows you to run through different scenarios based on different stress rates and rental cover rates.
What happens if I fail the stress test calculation?
If the property’s rental income doesn’t cover the mortgage interest repayments, some specialist buy-to-let lenders can also look at “Top Slicing“.
As mentioned earlier, top slicing is where lenders factor a borrower’s personal income into the affordability calculations to ensure they can still cover the mortgage repayments.
Not all lenders are willing to use this approach. But a specialist mortgage broker will have good relationships with those that do.
Other factors that may influence a lender’s willingness to overlook rental income shortfall are:
- increasing the deposit you put down;
- choosing a longer-term fixed-rate product of 5 years instead of 2 years;
- And, if you’re a portfolio landlord, lenders can be more flexible.
How much deposit do I need for a buy-to-let mortgage?
To get a mortgage on an investment property, you’ll generally need a deposit of at least 20-25% of the property’s value. The greater the deposit you put down, the broader the range of deals open to you.
You’ll often unlock cheaper rates with a greater deposit, too. The best buy-to-let deals are usually available to landlords who can put down a deposit of 40%.
Work out how much you could borrow with our no-obligation buy-to-let mortgage calculator.
How to choose the right buy-to-let property
Before choosing a property to buy, you need to decide what kind of tenants you want. Do you plan to let to students or young professionals? Maybe families or people moving home in need of temporary accommodation?
Your decision will determine the type of property you should buy, and where to search for it. If you’re not a seasoned landlord, select areas that you know well and are not too far away from where you live.
Other points you need to consider well ahead of your initial investment are:
- How much you are looking to invest?
- Are you looking to purchase the property using cash only or will you need a buy-to-let mortgage?
- What is your investment strategy?
- Do you want to create a monthly income, capital appreciation or both?
- Do you want to own the property in your own name or through a limited company structure (also called an SPV, special purpose vehicle)?
- Are you looking to own a portfolio of investment properties or just stick with one?
- What type of investment property do you want: houses, flats, student lets or commercial?
- Do you want to self-manage your investment property or utilise the services of a letting agent?
Once you’ve decided the type of property and area, talk to local estate agents. They can point you towards suitable properties, give you valuable feedback about the local rental market and help you narrow down your search.
Selecting a letting agent for my buy-to-let property
If you have a full-time job and not a lot of free time, letting agents can do all the hard work for you. For a comprehensive service, you’ll usually have to pay them around 10 to 15% of the rental income.
- Find you tenants;
- Run the necessary credit and legal checks;
- Take care of the maintenance;
- Collect rent on your behalf.
Alternatively, you can deal directly with your tenants and keep all the rental income.
Tax and fees on buy-to-let
Besides the mortgage, you’ll need to factor in other taxes and fees. Not all are applicable; some kick in at their respective thresholds. The details are here:
Stamp Duty Land Tax on buy-to-let properties
Buy-to-let, second homeowners, and limited companies pay a 3% surcharge on top of residential SDLT rates.
Our buy-to-let Stamp Duty calculator will give you a clearer idea of how much Stamp Duty you’ll need to pay when you purchase a buy-to-let property.
Income tax on buy-to-let properties
The rental income you receive is taxable and you will have to declare this as part of your Self- Assessment tax return. The tax on your income is then charged as per your income tax banding (20% for basic rate taxpayers, 40% for higher rate, and 45% for additional rate).
However, you can minimise the tax you have to pay by deducting certain ‘allowable expenses’ from your taxable rental income.
Allowable expenses include:
- Interest on buy-to-let loans: tax relief applies only to basic rate taxpayers;
- Council Tax, building and contents insurance, ground rents, etc.;
- General property repairs and maintenance (excluding large improvements, such as extensions);
- Legal, management and other professional fees, such as letting agency fees;
- Advertising for new tenants;
- Buildings insurance.
Capital Gains Tax on investment properties
You pay Capital Gains Tax (CGT) when you sell an investment property. You’re taxed on a portion of the profit – or capital gain – you make from the sale.
You only pay CGT on the property’s rise in value. So, if you purchased your buy-to-let property eight years ago for £300,000, then sell it on for £600,000, CGT would only be payable on the £300,000 difference between the two.
Capital Gains Tax on property is currently charged at a rate of 28% for higher-rate and additional-rate taxpayers or 18% for basic-rate taxpayers. Again, this is only payable on the amount of the chargeable gain.
But be careful. Your property gain could push you from a basic- to a higher-rate taxpayer during a tax year, meaning you will need to pay CGT at the 28% rate.
Do you pay inheritance tax on buy-to-let properties?
You are liable for Inheritance Tax on buy-to-let properties. But, the amount varies depending on your circumstances. Like all properties that you own, a buy-to-let property will form part of your estate for Inheritance Tax purposes.
Let’s look at quick examples:
1. you operate as a sole landlord and your estate is owned in its entirety by you alone:
- you’re liable for Inheritance Tax on any equity (or combined value of your estate) that exceeds £325,000.
2. you’re operating with a married or civil partner:
- you each have a threshold of £325,000, so Inheritance Tax kicks in at £650,000.
3. Anything above these amounts is taxed at 40%.
Inheritance tax planning is complex. You should discuss your liability with an expert tax or financial advisor.
Buy-to-let mortgages for limited companies
Buy-to-let mortgages for limited companies are another way to buy homes for rental. The company owner/director takes out the mortgage through a limited company rather than in their own name.
In recent years, we’ve seen cuts to both mortgage interest tax relief and wear and tear allowance. These changes have resulted in many landlords setting up company structures to facilitate their buy-to-let property investments.
Moving to a company structure isn’t the right decision for everyone, however. The interest rates on these deals tend to be slightly higher than those available to individual borrowers.
Taking out buy-to-let insurance is not a legal requirement for landlords. However, many mortgage lenders insist you have the right policy in place before you complete your buy-to-let mortgage.
Buy-to-let landlord insurance should cover:
- Damage to the property structure and permanent fixtures;
- Rebuild costs in the event of fire, flood, vandalism, storm or subsidence;
- Contents, if you rent out a furnished or partly furnished property;
- Property owners’ liability: this is essential cover;
- Loss of rent:
- You can claim if the property is unfit and not safe to live in after an incident like fire or flooding;
- You can get rent guarantee protection, which covers loss of rent if your tenant is still living in the property but not paying rent;
- Legal expenses, to cover legal costs for potential disputes with your tenants, such as costs in a liability case or legal action you need to take for evicting tenants.
What are the responsibilities of a landlord?
If you’re looking to become a first-time landlord, you should understand your legal responsibilities regarding any properties you let.
As a landlord, you must:
- keep your rented properties safe and free from health hazards;
- ensure a smoke alarm is fitted on each floor of the property;
- ensure carbon monoxide detectors are placed in rooms with solid fuel-burning appliances, such as a coal fire or wood-burning stove;
- reduce fire risk by ensuring all furniture meets safety standards, and display the appropriate labels;
- ensure the water supply is working properly to protect tenants from Legionella/water-borne viruses;
- ensure all gas equipment (pdf) and electrical equipment are safely installed and maintained;
- provide an Energy Performance Certificate for the property;
- protect your tenant’s deposit in a government-approved scheme;
- check your tenant has the right to rent your property (if it’s in England);
- give your tenant a copy of the “How to Rent” checklist when they start renting from you (you can email it to them).
Current and future EPC requirements for landlords
The government have proposed that all rental properties will need an EPC rating of ‘C’ or above by 2028.
Currently, properties only require an EPC rating of E or above. Existing tenancies will have until 2028 to comply with the new rule changes.