Buy-to-Let Mortgages: What You Need to Know in the Current High-Interest Rate Environment

9 min
Important to know

A mortgage is a loan secured against your home. Your home may be repossessed if you do not keep up repayments on your mortgage or any other debt secured on it.

Buy-to-let mortgages are a great option if you are considering buying a property solely for investment. Mortgage lenders offer a buy-to-let loan to individuals buying a property solely for renting out to others. This type of mortgage differs from a residential mortgage, which is designed for people looking to buy a property to live in. 

This article explains everything you need to know about buy-to-let mortgages in detail, including how to calculate affordability, who can qualify for a mortgage, the tax-to-rate rules, and more. Read on. 

Is Buy-to-let a Worthwhile Investment?

Due to the rising interest rate and other government measures, many individuals are reconsidering getting a buy-to-let mortgage. The major question has been whether a buy-to-let investment is worthwhile. This is because property investment is not as attractive as it used to be. 

Before getting a buy-to-let mortgage, it is important to consider some important factors, one of which is the interest rates. The Bank of England has had to adjust base interest rates 14 times in the last 3 years. 

Interest rates, formerly at 0.1%, have witnessed a significant increase and are currently at 5.25%. Buy-to-let investors are now constrained to manage their portfolios in a high-interest rate environment, which affects return on investment.

The people most affected by rising interest rates are those with a buy-to-let mortgage loan. Tenants are also not left out, as rising costs incurred by landlords will invariably be passed down to them in the form of higher rents. 

Lenders assess buy-to-let mortgages using the interest coverage ratio (ICR). This ratio compares the expected rental income to the amount of interest repayment on mortgages. 

Lenders’ criteria differ. Most lenders require the projected rental income to surpass the mortgage payment by 125% for a basic-rate taxpayer to qualify. The requirement is different for higher-rate taxpayers, who are subject to a more strict 145%.

The risk associated with buy-to-let is quite significant. Therefore, it is ideal to have an alternative income source to cushion the effect of any unforeseen costs. This type of investment is not one to venture into on a short-term basis as it is time-demanding. 

Even so, buy-to-let is still a worthwhile investment, with the market remaining robust for investors. Reports have shown that the average rent has increased by 10.5% within the last 12 months. 

Many experts assert that there is still money to be made from the market, especially for properties situated in areas with a large population of students and workers. This pushes the demand for rental properties and invariably leads to an increase in rent.

What a Consumer Buy-to-let Is 

Some people find themselves with properties they would like to rent out due to unforeseen circumstances. These are called accidental or non-professional landlords, and they are the ones consumer buy-to-let is designed for. 

Like residential buy-to-let, the Financial Conduct Authority (FCA) regulates consumer buy-to-let. However, not all buy-to-let properties are under the FCA’s regulation. 

This is especially true of properties owned by professional landlords. These properties are not treated as consumer properties but rather commercial properties. 

Who is Eligible for a Buy-to-let Mortgage?

Although the eligibility criteria for a buy-to-let mortgage vary by lender, there are some areas of similarity among lenders. Before you can apply for a buy-to-let mortgage, you must be at least 21 and have a good credit score. Therefore, it is ideal to check your credit score before applying. 

If your credit score is low and you are looking for ways to improve it, check out this guide: Hot Tips to Improve Your Credit Score.

Additionally, lenders require a minimum initial deposit of 25%. The initial deposit amount varies among lenders, with some requiring a minimum deposit of up to 40%. Also, you will need to have a minimum annual earning capacity of at least £25,000 to qualify for a mortgage, especially as a first-time landlord.  

Are Buy-to-let Properties Profitable?

One of the things you will have to demonstrate to the lender before getting approved for a buy-to-let mortgage is the profitability of the property in question. You will need to know how to calculate rental yields to prove this.

Here is a step-by-step method of calculating rental yields 

  • Determine the property’s annual rental income. 
  • Divide the annual rental income by the amount you paid for the property.
  • Multiply the figure by 100 to arrive at a percentage. 

Several other costs will affect the property’s rental yields. They include insurance and maintenance costs, mortgage interest, and agent fees. Also, if the property stays empty for a period, it will result in a lower yearly rental income. 

Furthermore, you must prove to mortgage lenders that you can pay the mortgage even if the interest rate rises within the repayment period. The interest rate varies depending on your tax bracket. 

For instance, the rent for a basic-rate taxpayer is about 5.5%, equal to 125% of the interest. A landlord in a higher tax bracket will pay as much as 145% of the interest rate.

Are the Interest Rates for Buy-to-let Higher than Residential Mortgage?

Buy-to-let mortgage interest rates and other associated fees are higher than those of a residential mortgage. However, buy-to-let mortgages are offered to investors on an interest-only basis. Although this may result in the payment of a lower interest rate than a standard repayment mortgage, it does not affect the amount owed in general.

However, you can access a more flexible repayment plan with a buy-to-let mortgage. This makes it easy to repay a large part of the loan annually at a period where you made the most profit from your rental income.

Before investing in a buy-to-let property, check to know if a penalty fee is attached if you fail to repay at the scheduled date. This is especially necessary if you have a fixed rate. 

If you are unable to pay off your mortgage, you can sell the property to complete payment. However, this will only work if the price of houses remains stable. If the prices of houses fall, you may need to make up for the difference if you run into negative equity.

Having a financial nest to cushion the effect of any unforeseen circumstances is ideal. A financial cushion will help ensure that your housing investment does not crumble.

Buy-to-let Tax Changes in the United Kingdom 

Several tax changes have occurred in the United Kingdom, affecting the tax levied on buy-to-let properties. In April 2016, a 3% stamp duty surcharge was levied on buy-to-let properties, including second homes in Northern Ireland, England, and Wales. Stamp duty is the tax an individual pays when they buy a property in the United Kingdom. 

Property owners are required to pay a 3% stamp duty surcharge on their property in addition to the normal stamp duty rates. For instance, if you acquire a rental property worth £500,000, you will have to pay an extra £15,000 as a stamp duty surcharge. Stamp duty is a bit higher for buy-to-let landlords in Scotland, as they are required to pay an extra 4%. 

Additionally, buy-to-let investors are required to pay income tax on rental income before deducting any mortgage expenses. Under the new tax law, landlords can maximize the 20% tax credit on mortgage interest repayment now available.

While this may seem generous and has little or no effect on landlords in the basic tax bracket, it is not so for higher-rate taxpayers. Because of the new way of calculating taxes, landlords whose income tax is in the 40% bracket will pay more than they did before the tax changes.

How to Calculate Buy-to-let Tax

Let’s assume you receive a monthly rental income of £2,000 on the property and must pay a monthly mortgage interest of £800. 

If you ignore other incurred expenses set against the tax, the calculation will be as follows:

  • Annual rental income: £2,000 × 12 = £24,000
  • Annual mortgage interest paid = £9,600

Tax due on annual rental income is calculated thus:

  • You will be required to pay tax on the full £24,000 annual rental income you earn, and the amount you pay is dependent on your tax bracket. 
  • You will pay £9,600 in annual mortgage interest.
  • You will get a tax credit of £1,920 (20% of £9,600)

Depending on your tax bracket, here is the tax due on the income:

  • As a basic taxpayer, the due amount is calculated at 20%: £4,800 – £1,920 = £2,880
  • As a high-rate taxpayer, tax is calculated at 40%: £9,600 – £1,920 = £7,680

Before the tax change, basic and high-rate taxpayers will deduct the amount due for their mortgage interest payment from the rental income. Afterward, the tax will be calculated using whatever is left after the mortgage interest has been deducted. 

How to Reduce Tax on Buy-to-let Properties

It is possible to pay a lower amount in tax on a buy-to-let property. One way to cut costs is to buy the property through a limited liability company. 

Working with an experienced expert to guide you through the entire process is ideal. Purchasing the buy-to-let property through a limited liability company means all costs (mortgage interest inclusive) can be written off as business expenses.

The company will be required to pay corporation tax, which starts at 19% if the income is below £50,000. As a property owner, your income can be paid out to you as dividends. 

According to the 2023/24 tax law stipulations, no tax is levied on the first £1,000 of dividends. However, taxes are paid on any additional withdrawals made after the first £1,000 and calculated thus:

  • Basic-rate taxpayers pay 8.75%.
  • Higher-rate taxpayers pay 33:75%.
  • Those in the additional-rate taxpayer’s category pay 39.35%.

You will also consider the possible payment of capital gains tax on any profit you make from selling the property. If you need to withdraw the money, you will also be required to pay income tax. 

Purchasing a buy-to-let property through a company gives you the advantage of taking your money at a time that is most suitable for you. This could be during a period when other income is minimal, say, in a tax year.

Do I Need to Pay Capital Gains Tax on a Buy-to-let Property?

If you sell the buy-to-let property at a profit, the proceeds will be subject to capital gains tax (GCT). However, property owners are entitled to an annual capital gains tax exemption of £3,000 beginning from 6 April 2024. This amount is low compared to £12,300 and £6,000 allowances in 2022 and 2023, respectively.

CGT is charged 18% for basic-rate taxpayers, while higher-rate taxpayers are charged 28%. If you are a basic-rate taxpayer, gains on the property will be calculated as part of your income which can push your income into the higher-rate tax bracket. The new tax payment system favours the basic-rate taxpayers over those in the higher-rate band. 

Do I Qualify for Buy-to-let Mortgage as a First-time Buyer?

You can qualify for a buy-to-let mortgage even as a first-time buyer. However, to get approval for your mortgage can be challenging because many lenders consider approving a mortgage for first-time buyers as posing greater risks.

As a first-time buyer, your mortgage offers will be limited. Therefore, you will need to make a big initial deposit to secure a good deal. Mortgage lenders will consider your peculiar circumstances and evaluate your reason for wanting to invest in a buy-to-let property, even without owning your own home. 

An expert mortgage broker can help you access the best mortgage lenders who are more favourably disposed toward first-time buyers. 

Should I Invest My Pension in a Buy-to-let Property?

You will need to exercise caution before deciding to use your pension to invest in a buy-to-let property. If you withdraw your pension, only the first 25% is tax-free. The rest of your pension will attract an income tax.

Aside from the income tax on your pension, you will also incur the following additional costs:

  • Stamp duty on the purchased property. 
  • Capital gains tax if you later sell property at a profit. 
  • Tax levied on your rental income.

If you leave the property to a family member after your demise, you will also be liable for an inheritance tax. Your pension, however, is not subject to an inheritance tax. 

Important Information:

Tax treatment depends on your individual circumstances and may be subject to future change. Your capital is at risk. All investments carry a degree of risk and it is important you understand the nature of these. The value of your investments can go down as well as up and you may get back less than you put in.

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Luca Bertolino

Mortgage Expert

Your Mortgage Experts is led by Luca Bertolino with 20 years experience in financial services and in the property market. Through Luca’s wealth of knowledge and expertise, Your Mortgage Experts have become a trusted adviser that clients have come to rely upon for all their mortgage and protection needs.

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