Understanding key terms and essential steps

Finance

There are three main ways to finance to your property purchase, cash purchase, getting a loan from a bank (mortgage) or getting an investor.

1. Cash Purchase: This is when you buy the property outright using your own cash reserves. This option may be suitable if you have substantial savings and are not interested in taking on debt or paying interest on a loan.
2. Mortgage: A mortgage is a loan from a bank or financial institution that allows you to purchase a property. You will need to make a down payment (deposit) on the property, and the rest of the purchase price will be financed by the lender.
3. Investor: Another option is to secure an investor to finance your property purchase. This may be a private individual or a company that is willing to invest in your real estate venture. In exchange, they will expect a return on their investment, which may involve sharing ownership or profits from the property.

Each of these financing options has its own advantages and disadvantages, and the choice will depend on your personal financial situation, goals and preferences.

This document focuses on financing your property via a mortgage.

Deposit

The first step towards buying an investment property is to save up your deposit.

A good strategy for building your deposit is to cash flow it. This means making a plan for how much you will save each month and sticking to it. You’ll also need to create and follow a budget to ensure you have enough money to put into savings. Additionally, you could consider taking on a side hustle to generate additional income, as well as look into using a high-interest savings account to help you save more money faster. Finally, make sure you’re taking advantage of any available tax breaks or credits to help you increase your savings.

Mortgage

You cannot use a conventional mortgage for investment purposes and will need what is called a Buy to Let (BTL) mortgage.

A Buy to Let (BTL) mortgage is a mortgage specifically designed for landlords looking to purchase a property in order to let it out to tenants. The requirements for a BTL mortgage are different from a conventional mortgage. The amount you can borrow is usually dependent on the potential rental income you can generate from the property, as well as your own personal income.

The rates on BTL mortgages tend to be higher than on a conventional mortgages and are only available to landlords who intend to let the property out to tenants and will not be used as a main residence.

Interest Rates

The interest rates for BTL mortgages are usually higher than owner occupied mortgages and will vary depending on the size of the loan, the loan to value (LTV) ratio and your credit record.  

There are two main types, variable and fixed rate mortgages.

Variable Rates

A Variable Rate Mortgage is a type of mortgage loan in which the interest rate is adjusted periodically based on market rates. This means that your monthly payment will fluctuate with changes in the market interest rate. Also, you have the potential to save money if market rates decline, as payments can decrease with the lower interest rate. The drawback is that your payments will increase if market interest rates go up.

There are three main types of variable rate mortgages:

Standard variable rate (SVR)

A standard variable rate is an interest rate charged by the bank that is not fixed and may be adjusted periodically throughout the course of the loan agreement. It may go up or down from time to time depending on the market conditions. This type of rate is linked to the bank’s prime rate, so if the market interest rate increases so does this rate however the borrower would benefit from any drop in interest rates.

Discounted variable rates

This is a variable rate offered at a discount of the banks standard variable rate. The discount rate is a percentage off the standard variable rate (SVR) and is typically available for a set period of time. If the bank’s standard variable rate (SVR) is 5% and they offer a 1.5% discounted rate, your interest rate will be 3.5%. If the lenders’ SVR goes down to 4.5%, your interest rate will go down to 3% and if it increases to 6%, your interest rate will increase to 4.5%.

Tracker rates

These are rates that track another interest rate, usually the Bank of England (BoE) base rates. If the bank offers a base rate + 1.5% and the BoE is 2%, you will pay a rate of 3.5%. If the BoE rate increases to 2.15%, your rate will increase to 3.65% and if it reduces to 1.5%, you will pay a 3% interest rate.

Fixed Rates

Fixed rate mortgage are mortgage rates that are locked in for a period and cannot change, regardless of market conditions or the lender’s costs. A 5-yr fixed 3% mortgage rate will be fixed for the entire 5-year period regardless of what happens with the Bank of England rates.

Fixed mortgage rates usually offer a stable monthly payment and long-term financial security, since there is no worry about rising rates. However, they are typically more expensive than variable rates.

Early Repayment Charge

An Early Repayment Charge (ERC) is a payment made to the bank for paying any part of your mortgage before the agreed term. This also applies to any over-payment by more than an amount allowed by your bank.

This is something to consider when choosing what type of mortgage you go for.

For example, if you borrow £75,000 on a 5-year fixed term mortgage with a 2% ERC and choose to repay after 4 years because you sold the property, you will need to pay an ERC. Assuming you still owe the entire £75,000 because you were only making interest payments:

• Balance owed to the bank: £75,000
• Early repayment charge: 2%
• ERC to pay: £75,000 x 2% = £1,500

You will need to pay an additional £1,500 to bank along with the £75,000 owed, a total of £78,500.

Fees & Other Costs

Banks will usually charge a fee in the form of an arrangement fee or product fee. This can sometimes be added to the loan or may be required to be paid upfront.

Arrangement fee

This is the fee for the mortgage product and is sometimes known as the product fee or completion fee. This can sometimes be added to your loan but will increase the amount you owe, your interest and your monthly payments.

Booking fee

Sometimes called an application fee and charged when you simply apply for a mortgage product and is not usually refundable even if your mortgage falls through. Some mortgage providers will include it as part of the arrangement fee, while others will only add it on depending on the size of the mortgage.

If possible, use a broker that does not charge upfront fees and takes it’s commission from the lender

Other Costs

Valuation fees

Your mortgage company will require a valuation of the property which you need to pay for in order to obtain a mortgage. They need to ensure the property is worth the price and is good security for the amount you wish to borrow. Some lenders won’t charge this fee on certain mortgage deals. The lender’s survey only looks at the property value.

Broker fees

This fee is for the mortgage broker, if you choose to use one, for arranging the mortgage or giving you advice. Some mortgage brokers won’t charge a fee and instead take commission from the mortgage provider.

Stamp duty

Stamp duty is a tax payable to the government whenever you by land or property (freehold or leasehold). You’ll only need to pay this if the property you are buying is over a certain threshold.

Conveyancing fees

These are costs associated with the legal aspect of buying or selling a property. These include the legal fees, obtaining searches, registering the property with the land registry, ID check and dealing with the stamp duty.

Insurance

Your mortgage company will require you to insure the property on completion.

Property costs

Depending on what state the property is in, you need to set aside some money to get it ready for rental. It may be just a good clean or complete refurbishment. You also need to set aside some money to cover the rent until the property is tenanted.

How much can I borrow?

Here are some useful terms to that will help to understand how much you can borrow:

Loan to Value (LTV)

Criteria differ by lenders. Most mortgage providers will lend 75% of the purchase price of the property although there are a few who will go up to 85%. This is known as Loan to Value (LTV).

For example, an LTV of 75% means the bank will lend up to £75,000 for a property price of £100,000

Rental Yield

Rental yield is used by investors to assess the potential profitability of a property investment. It is a measure of the income that an investment in real estate generates from rental payments in relation to its current market value. It is calculated by dividing the annual rental income of a property by its current market value or purchase price usually expressed either as a percentage.

Using the above example:

• Property price/value: £100,000
• Annual rental income: £6,000
• Rental Yield: £6,000/£100,000 = 6%

Rent to Interest (RTI)

It is generally assumed that the mortgage will be paid from the rental income. The rent to interest (RTI) cover is a metric used to measure the amount of income generated by rental property relative to the debt service payments associated with financing the property. It measures the amount of money that can be used to pay the interest payments on a loan.

Each lender will set their respective minimum RTI but is typically about 145% of the monthly mortgage repayment for individual applicants and 125% for limited company applicants.

To ensure you are able to afford the mortgage from the rent and during void periods, the bank also applies a “stress” test which could be up to 2% above their actual rate.

To work out the minimum rental cover, you need to multiply the RTI by the annual interest to pay.

So, using the above example,

• Loan = £75,000
• Monthly interest = 4%
• Monthly interest payment using stress test @ 6% = £375
• Using a RTI of 145%, the minimum rental amount must be 1.45 x £375 = £543.75
• Using a RTI of 125%, the minimum rental amount must be 1.35 x £375 = £468.75

Other Criteria

Other criteria that are considered in determining how much you can borrow and will vary by banks are (not an exhaustive list):

• Minimum and maximum loan amount: Some banks have a minimum and maximum loan amount they are prepared to lend.
• Minimum income: Some banks have a minimum income amount per individual applicant.
• Employment status: Most banks will require the applicant to be employed and some will accept self-employment.
• Minimum and maximum age: Banks usually have a minimum and maximum age per applicant.
• Credit history: Banks have different credit scoring mechanisms.
• Property type (non-standard construction, HMO, student): Some banks will not accept certain types of construction or tenant profile.
• Property location: Some banks are only prepared to fund properties in certain locations.
• Number of BTL properties in your portfolio: Some banks will consider the number of properties in your portfolio before deciding to lend.
• If you are a homeowner: Some banks require you to be a homeowner before they will offer a BTL mortgage.

Applying for a mortgage

Although there are lenders who will deal with you directly, most mortgages are only available via mortgage brokers therefore they tend to have a wider selection of mortgages available,

If you are new to this, I strongly recommend you speak with a mortgage adviser to find the mortgage suitable for your needs. When selecting a mortgage broker, it is essential to check that they are independent, otherwise you may receive biased advice.

I’d love to hear your thoughts. Leave a comment below and tell me whether you agree or disagree and why.

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The opinions expressed in this article are solely my own and should not be taken as expert advice. When making any decisions regarding purchasing or managing property, it is important that you seek the advice of an experienced professional.