Buy to let - Back to basics part 3
June 7, 2021
The third part of our buy-to-let basics series covers the topic of financing and we look at buying with cash or taking a buy-to-let mortgage.
As a quick recap, Vesta believes the following should be considered by anyone interested to get started with investment property:
- Is being a landlord right for me?
- Setting property goals
- Financing a buy-to-let property
- Costs of acquiring and running a buy-to-let property
We have covered the first two points already and today we will take a look at the third point
Financing a buy-to-let property
Having the finance in place is everything in property - it is the lifeblood of transacting - so it's important to understand and decide what is best for you.
Cash vs buy-to-let mortgage
If you are buying outright with cash, then you will be in a very strong position to negotiate a good deal on a property because you are not relying on additional funding from a mortgage and you are unlikely to be in any kind of chain. This means that you can act quickly which is very attractive to sellers who are looking to complete on a property sale within a shorter time frame than the typical 3 to 6 months (and sometimes even longer in recent times). You should be mindful that timescales vary depending on the buyer’s and/or seller’s circumstances and that conveyancing problems can arise and add delays. For example, the recent stamp duty holiday in England, Wales and Northern Ireland has added severe conveyancing delays as solicitors have found themselves inundated with buyers looking to benefit from the holiday.
So, if you are buying with cash be sure to state your position and also try to use that to negotiate a good deal. Most experts agree that you make money when you buy a property by locking in equity from the outset. Buying at a discount also de-risks an investment, so it is well worth leveraging your cash buyer position to the maximum advantage to secure a good deal. Note that properties that are very attractive to you are likely to also be very attractive to other investors and so you might not always get a better deal however being a cash buyer does give you an advantage over other investors that required funding support to complete the transaction.
If you are putting down a deposit - which can be 20 to 40% for buy-to-let - then you will need to source a mortgage to make up the difference. You should start the process of seeking finance as soon as possible and you also need to understand the criteria related to the finance you obtain as some lenders will not lend on certain BTL properties, e.g. HMOs, etc.
Vesta has partnered with award-winning specialist mortgage brokerage Coreco, to provide advice on funding, mortgage and debt solutions for buying and also refinancing investment property. You can find out more here.
Speaking to a reputable mortgage broker early on is very important
If you are not a cash buyer, having the finance in place is everything in property - it is the lifeblood of transacting - so it is very important to understand that you can access buy-to-let mortgages with your individual circumstances and the types of properties you want to buy.
Some people will often just go to their bank and ask about in-house mortgage products, but we recommend speaking to a mortgage broker who is “whole of market” as they will have access to a much wider range of products, including those from specialist BTL lenders who have much more competitive products than the High Street banks and can accommodate a variety of different property types. This becomes especially relevant if you are looking to buy an HMO as many mortgage products are restricted to experienced landlords and some lenders will only accept applications from people who have been landlords for two years or longer, and/or have experience in HMO letting.
A mortgage broker will take you through a detailed “fact find” to ascertain your creditworthiness and determine which products you can access.
You can secure what is known as a “decision in principle” from a lender which is a preliminary agreement that you have met their criteria for lending. This is important for when you come to put in offers, as the vendor will want to know how you intend to finance the purchase and if you have everything in place to move forward. At Vesta we will often request proof of funds and evidence of your funding position to ensure you are transaction-ready before an offer is made.
Securing a buy-to-let mortgage
Securing a buy to let mortgage is fairly straightforward as the lending is based more on what rental the property will achieve in income, rather than the income of the borrower.
Typically, you will need a minimum salary of £25K, a clean credit rating, and have been on the Electoral roll at your current address for 3 or more years.
Affordability for buy-to-let mortgages is typically assessed by looking at the interest coverage ratio (ICR). This is the ratio of gross rental income to mortgage interest repayments.
Lenders typically look for a minimum ICR of 125% calculated using an appropriate stressed interest rate (stressed ICR). A stressed ICR of 125% reflects the amount of gross rental income required for landlords to break even, factoring in the costs of mortgage repayments (including a potential increase in interest rates), tax and property maintenance.
Most lenders assess higher-rate taxpayers against a minimum stressed ICR of around 145%. So compared to basic-rate taxpayers, lenders are accepting a lower net rental income for given mortgage repayments for higher-rate taxpayers.
Most lenders now use a variation of the following calculation to determine how much they will lend:
- Monthly rent x 12 divided by 5.5% divided by 125 or 145%.
So, for example, if you were buying a property for £200K with £1,000 pcm rent, the maximum loan the lender would agree to is £150,470. This means you would have to put in a deposit of circa £50K.
The above calculation is a very useful way to assess a deal as a high-yielding property will likely mean that you will need to put in less of a deposit.
The next choice you will need to make is whether to go for a fixed rate or variable rate mortgage. A fixed-rate mortgage is when the interest rate remains the same for a set period, which can be between 2–5 years and sometimes longer. This is a good option when you need peace of mind that your repayments will stay the same each month. A variable rate mortgage tracks the Bank of England’s base rate at a set percentage above or below it. So, if the base rate of the Bank of England rises or falls the monthly interest payments on your mortgage will do the same. If you were to choose this type of mortgage you need to be sure that you can afford the mortgage repayments if the rates went up.
Again, you can discuss this with your mortgage broker to find the product that is right for you, your property, and your goals for the property.
Deciding on interest-only or repayment mortgage
You will also need to decide whether you are going to apply for an interest-only or repayment mortgage.
Most buy-to-let landlords favour the interest-only option as the monthly net cash flow will be greater than if you have a repayment element to the mortgage.
Furthermore, the way the repayment is calculated, for the first third of the mortgage term only the interest is being paid off, so the capital element is not being bitten into for many years.
Most interest-only mortgages come with an option to pay off some of the capital in a lump sum - usually up to 10% of the outstanding balance in one year - so this does provide flexibility if you do wish to pay down your BTL mortgage.
It is important to understand that an interest-only mortgage means you are not paying off any of the capital. So, at the end of the mortgage term is typically 20 years, you will still owe the lender the original amount.
However, taking an interest-only option means the debt is not repaid until you sell the property or via some other means, so you will need to weigh up the income versus the interest costs. Some investors will prefer to clear the debt before using the rental income which means in the long term, they create a debt-free property asset that also provides income.
It is therefore vital to have a plan about how you will repay the debt at the end of the term if interest only is selected.
- Selling the property
- Taking out a mortgage with a new lender to redeem the original one
- Having another vehicle in place, such as an inheritance or sale of a business or the sale of another property, that will provide the necessary funds
Most landlords use buy-to-let mortgages as it enables them to leverage their monies to the maximum and invest in multiple properties, rather than buying one property outright for cash.
The decision you make in this regard will depend on your personal circumstances, your tax position, and your attitude to risk, amongst other things. Again, your broker can advise you on all these issues and help you to make the right choice.
What does a lender look for?
A buy-to-let lender will typically need to see:
- Evidence of your income
- Copies of your bank statements
- Evidence of your identity and the address where you reside, including being on the electoral roll
- If you are self-employed, the lender will need your last three year’s accounts
There will be additional documents that a lender will ask for, depending on your circumstances.
You will also be required to pay for a valuation of the property. This is primarily for the benefit of the lender to check the security.
The lender will lend on the purchase price or the market value, whichever is the LOWER, so if your property is down-valued by the surveyor, you can still go ahead with the purchase, but you will have to make up the difference by increasing the deposit.
If you are buying a new-build property, the likeliness of down-valuation occurring will be diminished, as the developer will undoubtedly be able to show the valuer “sold comparables” of other similar properties in the development.
There will also be a fee for the mortgage which can be added to the loan, and your broker will also likely charge a fee, so make sure you understand all the fees that are being incurred for the acquisition.
What happens when your offer is accepted?
Once the sale is agreed, the legal process will start and, when the time comes to complete, your solicitor will contact your lender and arrange to draw down the money on the completion date.
You will be required to transfer the deposit, the stamp duty payment, and any other searches and legal fee payments to your solicitor.
On the day of completion, you will receive a completion statement showing all the fees that have been incurred in buying the property.
We recommend that you make up a file for the property and keep all the paperwork that is associated with it in one place. You will need this information for many purposes, including your tax return.
A reputable broker and solicitor will assist you through this process and make it as seamless and stress-free as possible, so it is worth taking a bit of time to find the right team to work with, as they will be on your property journey with you, should you wish to continue to build a portfolio. At Vesta we assign a deal progressor to each transaction who will work with all parties to keep things moving, help solve any issues and help keep the transaction on track.