Buy to let gearing

Presuming that you have sorted out all other problems, squeezing the most out of your invested capital is not too difficult.  The most important way is to use the ready availability of finance, the increasingly competitive interest rates and high percentage loan to purchase price that lenders currently have to offer. 

But will you qualify for a mortgage and what options are there? The answers to these questions can be found in our mortgage section.

But consider carefully that it may not be the optimum position to own the property outright.  In fact your return may increase hugely if your purchase deposit is smaller and your purchase loan is large.  Borrowing to support an investment is known as gearing and can make a substantial difference in Buy to Let.

	Cash purchase example: A property costs £100,000 (your capital invested) It produces rent of £1,000 per month (£12,000 per annum) Costs (letting agents, maintenance etc) are £200 per month (£2400 per annum) The net income return per annum is £9600 (£12000 less £2400) The return on your investment is therefore your net income divided by your invested capital £9,600  /   £100,000   =  9.6% per annum

However, now consider the effect of borrowing money to support the deal.

Obtain an interest only mortgage on the property of 85%, namely  £85,000

The interest payments on this could cost £4,500 per annum.

	Gearing example A property costs £100,000 Financed by an £85,000 mortgage and £15,000 invested capital Costs (letting agents, maintenance etc) are £2400 per annum Mortgage interest of £4,500 per annum Net income return per annum is £5,100 (£12,000 less £2,400 and £4,500) The return on your investment is therefore your net income divided by your invested capital   £5,100 /   £15,000   =  34% per annum

The net income return has, of course, been reduced by these interest payments, namely £9,600 less £4,500, equalling £5,100 per annum.

But, of course, out of the purchase price of £100,000 with now an £85,000 mortgage, your capital that you have invested the property is now only your deposit, namely £15,000. So, your annual return on investment is now the new net rent figure divided by your deposit.

 £5,100  /  £15,000  =  34% per annum

This is a huge increase in return. It could allow you to stretch your available capital further and purchase more properties or simply retain it for other uses. An important presumption is that you can control the cost of the mortgage. It is possible to buy fixed rate loans for periods between two and ten years, and you may like to factor this in to your calculations.

However, do not be too frightened of interest rate changes, especially, of course, increases in rate. Again, a simple calculation shows, using our example above, that a 1% increase in interest rate on our £85,000 mortgage, would add £850 per annum to our mortgage cost. This would reduce our net income by this amount from £5,100 to £4,250 per annum. 

As our invested capital (our deposit) has not changed, the return on investment is now

£4,100  /  £15,000   =  27.33% per annum

This is still an excellent return. We can even consider the effect of a two per cent increase in interest rate.  This reduces the annual return on investment to 22% etc. Measure these figures against the return where there is no loan, namely 9.6%

This argument can be extended to advocate interest only mortgages over repayment mortgages. In a repayment mortgage you are starting at a point where your share of the property is at it’s smallest and ending up where your share is 100%.  In the above example this takes you from a starting return on investment of 34% to one of 9.6%.  You should therefore have a good reason for wanting a repayment mortgage. 

Bear in mind that most lenders will not want a structured method of paying back the capital (for example, the much maligned endowment) if you opt for an interest only mortgage, nor will they require any life insurance. The reason is simply that they view this as a pure investment, and if you are not happy with it for any reason, then you will simply sell the property and repay their loan.

If gearing works well, then it can be a good idea never to pay back the loan and to constantly maximise the borrowing as the property increases in value or as lenders change criteria on Loan to Value .  Extra income that you derive from the property or extra capital that you extract by re-financing can be invested elsewhere, for example in further properties. 

A number of lenders will allow interest only mortgages on an on-going rolling 25 year basis.  Arguably as a lender’s raison d’etre is to lend money, having it paid back is to be avoided.  Therefore rolling over loans or renegotiation of lending on death is open for discussion.

These options will very much depend on personal views and attitudes and whether your objective is for maximum income or maximum capital growth over a set period of time. Every investors risk profile and objective is slightly different and we are happy to discuss the individual options available.