Every landlord, whether they own a couple of properties or a couple of hundred, is running a business. Like any business, it’s a numbers game – and the numbers can often be unpredictable.
When Mark Carney took over from Mervyn King as the Governor of the Bank of England on 1 July 2013, the economy was still sluggish at best. Mr Carney indicated that the Bank would not implement interest rate increases until (among other things) unemployment fell to 7% – something not anticipated until 2016.
Current projections now suggest that this may be as early as 2015, however, indicating that central interest rate rises could well begin in the next 13–25 months. And that’s to say nothing of buy to let lenders’ own rates; this year, two lenders – the Bank of Ireland and West Bromwich Building Society – have jumped the gun by increasing their fixed differentials ‘in response to market conditions’.
This isn’t to say that the favourable investment conditions enjoyed by landlords will end – just that the nature of effective investment will change. When the Mortgage Market Review (MMR) comes into force in April 2014, residential borrowers will have their application ‘stress tested’ as part of new affordability checks in order to ensure that they will be able to afford increases in interest rates, and buy to let landlords should conduct similar checks.
Stress testing buy to let mortgage interest payments
Some 1.45 million buy to let mortgages were outstanding at the end of 2012, according to the Council of Mortgage Lenders (CML). This means that nearly 40% of the estimated 3.8 million households in the private rental sector are geared by some level of buy to let finance.
Whilst the MMR will only apply to the regulated mortgage market, it is a good idea for commercial property owners to implement some of the proposed checks where possible. Some might be untenable – for instance, the Review insists upon interest-only mortgages being loaned only where there is a ‘credible repayment strategy’. Many landlords take advantage of interest-only mortgages to maximise their profits, and switching to a repayment mortgage might well lead to their making a loss each month. In these instances, it is imperative to ensure that the repayment strategy (which will often be the sale of the property, but could well be another investment vehicle) is on track to deliver the full capital amount, and also to reduce the capital owed where possible (and where it would not adversely affect possible tax breaks, which I will discuss shortly).
Rate hikes will also have a more pronounced effect on interest-only loans, and stress testing against increases becomes all the more important. For instance, a 25-year, interest-only buy to let mortgage with a 4.0% interest rate would cost £500 per month. If rates were to rise by just 0.5%, this would increase by £62.50 (£750 per year); an increase of 1.0% would push them up by £125 (£1,500 per year). Conversely, if this were a repayment mortgage (costing £791 per month), the annual increases at 0.5% and 1.0% would be £504 and £1,008 respectively.
Experts suggest that you check whether you would be able to service both a short-term and sustained interest rate of 7.0% in order to be certain that your rental income will support your investment.
Repaying capital – the effect on tax
Rather than switching to a repayment mortgage, you might be tempted to make overpayments and reduce your capital owed. Aside from the possibility of early repayment charges, you might also find that your tax bill increases.
Buy to let landlords can offset their mortgage interest against their income when calculating income tax. In the above example, the £500 per month equates to a tax saving of £1,200 per year at the basic 20% rate. This becomes £2,400 at the higher rate, and £2,700 at the additional rate.
If you were to reduce your mortgage by, say, £20,000, you would save just under £800 per year in mortgage interest, and would pay £160 more per year in tax (£320 at the higher rate and £360 at the additional rate). The smaller the reduction, the narrower the margin, and with factors such as overpayment fees, you might find that your spare funds are better spent elsewhere – perhaps in naturally increasing the equity of your property by improving it (the cost of which, incidentally, can be offset against capital gains and used to reduce your tax liability upon the sale of your property).
There is no one-size-fits all approach to property investment, and no two investor’s situations are alike. The best approach for non-cash investors is to keep an eye on your investment and plan for a high-risk scenario (such as the 7% short- or long-term interest rate). If you could not service such a risk, consider a back-up plan, and contact your lender or mortgage broker to see if alternative financial arrangements might better protect you and your portfolio.