For UK investors buying to let properties, the type of mortgage they take out can have considerable implications for how much tax they’ll 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 loan amount. The main tax that would then be paid is capital gains, but it is levied at a lower rate than income tax. The advantage becomes particularly pronounced for people with high incomes, since they pay taxes 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 penalty risk-adjusted rate. Holders of mortgages in which 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 homeowners 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 mortgages. These reduce the risk of being trapped by a sudden and severe increase in interest rates.
Disadvantages include higher fees and less flexibility. In general, mortgage providers will also charge an early surrender fee on these types of products. That reduces the lessor’s flexibility to sell or remortgage to take advantage of changing market conditions.
With interest rates in the UK currently at record lows, the case for going fixed seems overwhelming. There is little to gain from 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 take out a mortgage almost as an afterthought. However, considered research in this area could lead to very different investment results.