Pros and cons of a high LTV buy to let mortgage

By Ben Gosling of www.commercialtrust.co.uk

The average loan to value (LTV) of a buy to let investment – the ratio between the loan size and the value of the property – tends to sit between 60 and 70%. But some landlords opt for 75%, 80% or even 85% LTV when taking out a new loan.

Here, we look at why someone might want a high LTV mortgage, as well as the pros and cons of opting for this potentially riskier option.

‘Gearing’

First, it might be handy to bust a little jargon.

‘Gearing’ – sometimes known as ‘leverage’ – is a term used in finance, and is another way of referring to the ratio of debt to capital. When investing money, it is important to make it work as hard as possible, and gearing can allow investors to achieve far higher returns by minimising the start-up cash needed.

A very simple example: imagine you purchased a £100,000 property using a £15,000 deposit, and then in three years’ time sold it for £115,000.

Assuming that the rent covered the operating costs throughout the three year period, your profit (after repaying the £85,000 mortgage) would be £15,000, meaning that you’d have doubled your initial outlay. Though the asset itself would only have appreciated by 15%, the return on your original investment would be 100% – more than six times the asset growth alone.

The pros of a high-LTV BTL mortgage

Low entry cost

One of the biggest barriers to property investment (and ownership) is the cost. Many novice or first-time landlords don’t have access to the capital required to put down a large deposit.

The immediately obvious benefit of a high-LTV buy to let loan is that it permits entry into the market at very low outlays. Subject to minimum property values, some landlords might be able to invest in a property with a deposit as low as £10,000 1.

Inflation

Property is often treated as a medium to long-term investment because, over time, house prices trend upwards. This means that, assuming it stays level, the relative size of your mortgage debt should gradually shrink.

So what starts out as an 85% LTV loan on day one might, after five years of steady price increases, become a 65–70% LTV loan. After 10 years, the LTV could be as low as one half.

Price inflation isn’t guaranteed, but the longer-term your investment, the more likely it is that your initial encumbrance will slowly shrink entirely on its own.

Spreading risk and returns

We already touched on boosting returns in the introduction to gearing. By using a larger loan to leverage your capital, it is possible to increase the return on your investment.

£54,000 could be used as a 45% deposit on a single property worth £120,000. By splitting this into three 15% deposits of £18,000 instead, you could purchase two more properties of a similar quality, and potentially triple the return on your initial outlay.

This also helps to spread certain investment risks: in a single property, rental arrears or voids effectively cut off your only line of income. If you had two more properties, then your income would only be down by a third.

The cons of a high-LTV BTL mortgage

Reducing your cash flow

Though it is possible to boost your return on investment with a smaller deposit, your cash flow is likely to take a hit.

A larger and (probably) pricier mortgage will accrue more interest. So whilst your initial outlay might be working harder, your overheads will be higher, and you will have less working cash flow month-on-month to reinvest in your property, set aside for emergencies, or simply put into your pocket.

The flip side of this is a reduced tax bill. Buy to let mortgage interest can be offset against rental income when calculating income tax; thus, the more interest you pay, the lower your tax liability.

Less equity

The way many landlords build buy to let ‘empires’ is by regularly releasing equity from their existing portfolio to fund new purchases. Of course, this strategy is dependent on their being enough equity in their properties to do so.

Even if you can release enough to fund a new purchase and remain within your lender’s LTV limits, your rent might not be enough to cover the new repayments by the required amount (usually 120–130%).

This makes a highly-geared portfolio more difficult to expand without finding cash elsewhere.

Added risk

Higher LTVs are naturally riskier. This is why lenders tend to charge higher rates and fees for higher LTV mortgages.

Though property values trend upwards, they can also fall, particularly in the short term. During last decade’s financial crisis, average values fell by around 15% 2– meaning that anyone with less than 15% equity in their property was at serious risk of falling into negative equity and being unable to sell without losing money.

There is also the fact that higher overheads means less cash for your contingency fund, meaning that you might need to pay for repairs or other emergencies out of your own pocket.

Conclusion

Ultimately, whether or not a high LTV loan is the right choice for you comes down to a number of factors.

If you are risk averse or after short-term returns, then a larger deposit might be necessary. On the other hand, if you are comfortable with the higher risk levels and happy to wait for longer to see your returns, then a higher LTV loan might be for you; similarly, it can be a good leg-up onto the ladder for budding landlords without a lot of capital to invest.

Every investor is different, as is every investment, and finding a strategy that works for you is one of the most important developments in your early career as a landlord.

 

References

  1. “Buy to let mortgage deposit requirements”. Commercial Trust. N.d. Accessed 12 Jun 2015.
  2. Based on house price index data for Nov 2007 to Apr 2009 retrieved from http://landregistry.data.gov.uk/app/hpi

This article is intended for information purposes only and should not be construed as providing investment advice.

Your property may be repossessed if you do not keep up repayments on a mortgage or any other debt secured against it.

The FCA does not regulate most forms of buy to let mortgage.

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