Introduction

In this blog, we explore what Buy to Let (BtL) property is and how it works. It's a pretty big deal, with nearly 1 in 5 UK households living in the Private Rented Sector (PRS).

The best place to start is by answering the question; What is Buy to Let property?

Simply put, buy to let properties are those that are purchased with the intention of generating an income by renting them out. 

The properties can be owned by individuals, or by companies, with different benefits and drawbacks for each method. 

Generally, buy to let properties are let to tenants on long term tenancies, which are defined as 6 months or longer. 

Approximately 60% of Buy to Let properties have been funded by a mortgage, meaning lenders have a significant impact on the industry through the terms of their mortgages. 

The Key Parties

The majority of BtL properties have 3 key parties.

• The Landlord
• The Tenant
• The Lender

Landlords

A landlord is a property owner that rents all or part of a property to a 3rd party, their tenant. 

Their primary role is to provide a safe property for their tenant to live in. They must ensure that property is compliant with the most up to date housing regulations. 

There is a misconception that all landlords are a Scrooge McDuck type figure, swimming around in their vault of money. The reality is that at 43%, almost half of the individual landlords in the UK have one property, with a further 39% of landlords owning between 2 and 4 properties. This means just 18% of landlords account for nearly half (48%) of the rented properties in the UK. 

While some landlords have intentions to become one, others fall into the role. 

There are many different approaches to the role, with some solely financially driven, with a ‘bottom-line’ decision making process. They tend to be professional landlords, and often the rent from their rental properties is their primary source of income.

There are also accidental landlords. These have become a landlord through circumstance, such as the result of a bereavement, where someone has been left a property in a will, or when a homeowner moves to a new property and is not yet ready to dispose of their current home. 

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Tenants

The tenant is the person living in the property, who pays rent to the landlord.

Without a tenant, a landlord has no income. They must be provided with a safe place to live, and in turn should make their rental payments at the agreed times. 

They are expected to act in a ‘tenant-like manner,’ meaning they must treat the property and their neighbours with respect and decency. 

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Lenders

The lender is a bank or building society that provides a mortgage to a landlord for the purpose of buying or refinancing a property. 

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With nearly ⅔ of buy to let properties having some level of mortgage funding, lenders have a significant impact on the private rented sector.  

Lenders prefer lending against properties let on long-term assured shorthold tenancies. These guarantee the tenant at least 6 months in the property, and grant the landlord, and by extension the lender in the event of repossession, the legal right to evict a tenant to gain vacant possession. 

How do buy to let mortgages work?

While the most important factor for owner occupiers is their income, lenders take several factors into account when determining if they will lend on a buy to let mortgage.

• The Rental Value
• The Property Value & LTV 
• The Interest Cover Ratio
• Prospective Maximum Mortgage Amount 
• Stress Testing 

The Rental Value

This is how much rent the property could achieve, accounting for the condition of the property and the market. This could vary from what the landlord receives.

Typically, if a property is rented out, the lender will use the rent from the tenancy agreement for their calculations, unless the rent seems to be abnormal for the area and property. 

Generally, the higher the rent, the larger the mortgage you can get.

The Property Value & LTV

The most common max LTV offered on Buy to Let mortgages is 75%. 

This means the owner must have a deposit, or equity, of 25% of the property value. This is significantly higher than residential mortgages, which often can go up to 90 or even 95% LTV.

The rent may determine that a larger loan could theoretically be taken, however the amount lent will be capped by the maximum LTV of the mortgage product.

The Interest Cover Ratio (ICR)

This is a key factor in the lending decision for buy to let mortgages.

The interest cover ratio is how many times the rent can cover the mortgage payments.

It provides a buffer between the rental value and the mortgage. This buffer can account for costs and taxes, leaving sufficient rent to pay the mortgage. 

It can be expressed as a percentage, such as 125%, or a number such as 1.25.

Lenders have different interest cover ratios for different entities. 

Private Limited Companies (LTD) usually need a ratio of at least 1.25

Individuals typically require an ICR of 1.25 to 1.45, which is usually linked to their tax status. Higher rate taxpayers tend to be closer to 1.45, with low rate tax payers closer to 1.25.

‍How to calculate ICR 

In this example, we are looking at an interest only mortgage.

To calculate the ICR, you need to divide the rent by the mortgage.

Using the figures from above;

• The annual rent is £12,000
• The annual mortgage is £9,000

Each lender will have a minimum viable ICR. If the calculations produces a figure above tbis, the mortgage application is more likely to be accepted.

Prospective Max Mortgage Amount

When you are looking to buy or remortgage a buy to let property, there is a simple formula you can use to see what size mortgage the rent could sustain. 

The final mortgage size will be subject to the underwriting process, and can vary depending on factors such as the location, age, tenant type etc, but this formula can give you an indicative max loan amount, which can be very useful.

With many landlords aiming to take out a 75% mortgage, it is important to understand if the rent they would receive would be high enough to borrow that amount of money.

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In its simplest terms, the calculation is:

So, taking a property that achieves a rent of £1,000 a month, the calculation would look like:

This is particularly useful when you are trying to work out if a buy to let property can work for you. 

Using the expected rental value, the lender’s calculation rate and the expected valuation of the property, you can have a good idea of the maximum loan that will be available to you.

Stress Testing

Now, we understand what ICR is, we know the formula, it is time to add some complexity.

When lenders are making the decision to lend, they need to think about your ability to afford the mortgage, now and in the future. To do this, they make an assessment of what they think the market may look like in the next 5 years.

To calculate the theoretical maximum mortgage amount, some lenders use a ‘stressed interest rate’ which is higher than the product rate. 

Usually, when taking a fixed product for 5 years or more, the lender will use the product rate to calculate the max loan. When taking a variable product, or one fixed for a shorter term, a stressed rate will be used. 

This stressed interest rate can have a large impact on affordability. 

The rate may be 3% higher than the product rate, greatly decreasing the loan available.

Let’s look at some numbers.

5 Year Fixed Rate Loan

In this example, the product rate is being used for the loan calculation as the product is a 5 year fixed rate.

2 Year Fixed Rate Loan

As the product is only fixed for 2 years, the lender is applying a stressed rate to ensure mortgage payments would still be affordable should the rate jump at the end of the fixed period.

They have added 3% to the product rate, giving a stressed rate of 7.5%.

When using the stressed rate, the maximum loan reduces by over £85,000! 

It is important to factor this in when you are considering your strategy around buying. The mortgage product may allow up to 75% LTV, however the rent would only be sufficient to borrow 64% LTV on a 2-year fixed rate. 

For some, a 5-year fix may not seem to fit into their long term strategy, particularly if they want the option to sell before then. 

In such cases, it could be beneficial to choose a product that allows porting. 

Porting is when a lender may allow you to charge the remaining balance of your mortgage against another property. You can do so without having to pay early repayment charges, potentially saving tens of thousands. The decision to lend on the new property will be subject to the lender's underwriting process at the time of the request. 

How to Choose a Buy to Let Mortgage

Our partners at GetDough see a lot of people asking about the lowest buy to let mortgage rates. 

Like many things, you should avoid being enticed by the best headline figure.

You should consider your property strategy and what is important to you in the short, medium and long term.

On the face of things, the lower the rate, the cheaper the monthly payments, the higher the profit. Seems pretty simple. The reality is that you should consider all aspects of a mortgage product before committing, including:

• The interest rate
• The type of mortgage
• The product fees
• The product features

The Interest Rate

This is how much interest is being charged per £1 borrowed.

A 5% rate would mean the borrower pays 5p per £1 borrowed, per year.

The lower the rate, the smaller the amount of interest paid.

The type of mortgage

There are different types of mortgage that can suit different strategies. 

Some inherently offer longer term cash flow forecasting, suiting risk-averse landlords, while others suit landlords with a higher risk tolerance, or are less likely to have restrictions on changing products. We look at the 4 most common:

• Fixed Rate
• Variable Rate
• Discounted Rate
• Tracker

Fixed Rate

The mortgage payments are fixed for a set period of time, such as 2, 3 or 5 years.

These can be good for risk averse landlords that prefer a guaranteed figure for cash flow forecasting throughout the life of their mortgage product. 

A landlord may elect for a longer fixed rate if they believe the interest rates available are likely to rise. Anyone that fixed a 5 year mortgage pre-Trussgate is probably laughing right now. 

Variable Rates

Each lender has a Standard Variable Rate (SVR). 

When a mortgage product ends, the borrower is automatically moved on to this rate. You can also elect to go on it when taking out a mortgage.

The lender will raise and lower this rate in line with where they believe the market to be,

Variable rates are less likely to have early repayment charges, which may suit landlords that expect rates to decrease, or want the flexibility to move providers or sell at any point.

Discounted Rate

This is a fixed timed product that allows for fluctuation in rate. It is set as a discounted percentage below the lender’s SVR. 

For example, the lender’s SVR may be 8%. The discounted rate product may offer 3% below SVR for a 5 year period.

These can be good for landlords that believe the mortgage market may see favourable changes before the BoE reduces the base rate.

You must keep in mind that the rate can go up, as well as down, and that the SVR is set by the lender. 

Tracker Rates

Tracker rates are set as a percentage in relation to the BoE base rate.

These can be set for a period of time, such as 2 years, or open ended.

These can be good for landlords that believe the base rate is likely to decrease over the term of their mortgage. 

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Product Fees

Most products have a fee. Nearly every mortgage will have a funds transfer fee of £20 or so. There are other fees that should also be taken into account when a mortgage:

• Application Fee
• Valuation Fee
• Arrangement/Product Fee

Application Fee

The application fee is due when the application is submitted, regardless of outcome. They can be a set amount, or a percentage of the loan requested. The fee is usually non-refundable. Toa video wasted funds, you should ensure accurate information was provided when you obtained your DIP, and that your broker has checked the lending criteria before submitting the application.

Valuation Fee

The valuation fee, if one is present, is usually paid when the application is made. This is the cost for the lender to value the property and confirm that it is suitable security for them to lend. 

Some lenders offer free valuations, while others can charge thousands depending on the complexity of the property.

Arrangement/Product Fee

This fee is paid when a mortgage is taken out. 

The good news is that you typically only pay this when the mortgage is successful, and many lenders allow the fee to be added to the mortgage balance. This can be good for short term cash flow, but interest will be charged on it, increasing the amount you pay back over time.

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Typically, products that offer lower rates have higher fees, although not always the case.

When deciding which product provides the best fit, you should consider how much you are able to pay up front, and how much tax you may be paying on any profit. 

As seen, there is nuance to finding the best deal, looking past the headline number. This is why we always use brokers to help us find the right product.

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Product Features

Mortgages can come with a variety of beneficial features. From allowing you to leave, to taking the mortgage with you, it’s important to understand what’s on offer.

Early Repayment Charges (ERC)

If you want to pay off a mortgage before the end of the product term, you usually have to pay an ERC. They could be 5% of the total loan, although they often decrease over the term of the product.

Mortgages can be offered without any ERCs, which is great if you think the rates on the market are likely to reduce over time, or you need the flexibility to sell without large financial penalties.

Portability

This allows you to transfer the remaining balance of your mortgage with you to another property, subject to the new property passing the lender’s unwriting process.

This is beneficial as you could keep your current interest rate, which is great if you’re on a 5-year fixed and do not need to pay any ERCs. 

Free Legals

Some lenders offer free legal services from their appointed conveyancer.

With legal fees anywhere from £500 to £1,500 depending on the complexity of the case, this can save you money to be used elsewhere.

You usually still have to pay for disbursements, such as searches, but saving a few hundred pounds is rather beneficial!

Cashback

Some lenders will offer cashback on completion. This can be useful if you’re tight on a budget, or a welcome boost to kit out your rental property.

Summary

Buy to let property can be exciting and lucrative when done correctly. There is increasing regulation in the sector, which is adding complexity to the industry. 

The 3 key parties are the landlord, the tenant and the lender, with the landlord having a relationship with both other parties. 

Landlords are ultimately liable for all compliance and regulatory needs of the property, even if they have appointed an agent. It’s best practice to understand any changes to legislation, even if you have an agent. 

When choosing a mortgage product, landlords should consider all factors of the mortgage, not just the headline interest rate. You are more likely to succeed when you have a strong strategy in place. Decide what you want to do, why and how, then try to stick to it. Some level of dynamism is important, however, as things don’t always go to plan. 

Next time, we discuss the benefits and drawbacks of owning properties in different entities, so keep your eyes peeled. 

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