For UK investors buying to let property, the type of mortgage they get can have considerable implications on how much tax they will pay, both over the life of the investment and just on a monthly basis. This can have a significant impact on total returns from purchase to rental investment. Unfortunately, there is no single mortgage option that is right for every real estate investment strategy, so prospective homeowners should research their options very carefully.
The first choice you must make is between an interest-only mortgage and one that includes repayment of the principal amount owed. Traditionally, most buy-to-let mortgages have been interest-only. This is because the interest paid can be deducted from the income received for income tax purposes. Therefore, many homeowners have wanted to minimize taxes by not reducing the amount of the loan. The main tax that would then be paid is capital gains tax, but it is levied at a lower rate than income tax. The advantage becomes particularly pronounced for people with high incomes, since they are taxed at a much higher marginal rate.
The downside to this type of mortgage is that during times of stress in the financial markets, homeowners can find their loan-to-value ratio easily stretched. This can make it difficult, if not impossible, to remortgage with another provider and also means they may end up paying a risk-adjusted penalty rate. Holders of mortgages where part of the principal is repaid along with interest each month reduce the size of the outstanding loan with each payment. This reduces the risks of them falling into negative equity.
The second main option is between a variable rate mortgage or a fixed rate. In the past, most homeowner’s mortgages were variable rate because the rates were a little lower and the rate was a little more competitive. However, an increasing number of residential real estate investors are taking out fixed rate mortgages. These reduce the risk of being caught in a sudden and severe increase in interest rates.
The disadvantages include higher fees and less flexibility. Mortgage providers will generally charge an early surrender fee on these types of products as well. That reduces the landlord’s flexibility to sell or remortgage to take advantage of changing market conditions.
With UK interest rates currently at record lows, the arguments in favor of going fixed seem overwhelming. There is little to gain with an adjustable rate mortgage and potentially a lot to lose.
Typically, beginners buy to allow investors to spend most of their time researching the real estate market and then get a mortgage almost as an afterthought. However, considered research in this area could lead to very different investment results.
