A guide to buy-to-let

Since back in April 2015 retirees have been able to take their whole pension as cash. This opened up a wide range of options, including investing the sum or using it to buy a property.

The combination of regular income from rental property alongside potential for house price growth is appealing. However, there are major pitfalls to this approach, particularly when it comes to tax.

Here's what you should consider before taking the plunge with buy-to-let property:

What are the tax drawbacks of buy-to-let?

Property is expensive, and while you can take 25% out of your pension as a tax-free cash sum, you will pay tax at your personal rate on the remainder. You could push yourself into the higher-rate tax band by taking a large sum out. Drawing smaller, regular sums across the years will prompt a lower tax bill.

If you buy a property to rent out and later sell it, beware capital gains tax on any profits made from the sale. This is charged at 18% or 28%, depending on your overall income and gains in a tax year.

Stamp duty is another potential major cost. Assuming you already own another property, buying an additional property for buy-to-let purposes will in most cases incur a 3% surcharge on your purchase.

Then there’s the matter of inheritance tax (IHT). If your buy-to-let mortgage is just in your name as an individual and owned only by yourself – then you’re liable to IHT if your property is valued above £325,000 (minus any outstanding mortgage or combined value of your estate).

If the buy-to-let property is jointly owned with your spouse or civil partner, then you each have a threshold of £325,000, with IHT starting at £650,000. Anything above these amounts will be taxed at 40%.

The downsides of buy-to-let

• You may have spells when the property is unoccupied and you won’t receive rental income.
• Managing a buy-to-let property can be a headache. Are you prepared to sort anything from boiler breakdowns to tenants who leave it in a state? And you employ a managing agent you will lose a sizeable chunk of your potential income.
• Moving from a tax-efficient environment in a pension to a single asset (one property) is a risky approach to investment. Typically, a diversified approach is better.

Read our guide to things to look for in a good buy-to-let property

What are the benefits of buy-to-let?

• Buy-to-let offers a regular income (aside from vacant periods) with the potential for capital growth.
• If you’re able to use your 25% tax-free lump sum to put down a deposit on a property, you avoid being tied to just one asset for retirement income.
• Rental yields can be attractive, averaging around 5% and reaching a 10% gross or much more in the right area.
• You will own a tangible asset. You may find this more appealing than a statement on an investment account.

Getting a buy-to-let mortgage

Unless you have enough money in a pension or other forms of saving to buy a house or flat outright, you will need to take out a buy-to-let mortgage, also known as a landlord mortgage. These loans are similar to residential mortgages, but there are some important differences.

How much you can borrow

The size of buy-to-let mortgage you can qualify for depends on a number of factors. These include how much deposit you have to put down, your credit score, and – most importantly – the amount of rental income your property is expected to generate.

Type of loan

Most landlord mortgages are interest-only: this means that repayments cover the cost of interest but do not serve to pay off the capital on the loan.

This makes such mortgages cheaper than repayment loans, but it means that you will need to sell the property at the end of the deal to repay the debt in full.

The risk here is that if prices fall, you may not get enough from the eventual sale to clear your loan.

Fees and rates

Annual interest rates on buy-to-let loans tend to be higher than on residential mortgages, as do administration fees.

The rate of interest you'll be charged will depend to a large extent on how much deposit you can put down, and normally this will be about 25% of the property's value. 

Age limits

As with standard mortgages, buy-to-let loans typically come with age limits: this means you can’t take out a mortgage which is scheduled to run past a certain age, often 70 or 75.

If you are forced to borrow over 10 or 15 years rather than the more common 25, your monthly repayments will be higher – although the total cost of interest will be less.

Deposits

Lenders usually require higher minimum deposit levels on buy-to-let mortgages: this is typically 25% or more, so if you're looking at a home on the market for £200,000, that means a deposit of at least £50,000.

Usually, lenders stipulate that the expected monthly rent should be between a quarter to a third higher than the cost of your mortgage repayments.

Repayments

The size of your monthly repayments will depend on the interest rate and the length of your loan: there are numerous online BTL mortgage repayment calculators which will show how much you will have to repay based on these factors.

Extra purchase costs

Your deposit isn’t the only upfront cost you’ll face and the bad news is that stamp duty rates for landlords have been increased significantly this year. Since April 2016, buyers of second homes in England have faced a 3% stamp duty surcharge, so they must now pay 3% of the purchase price as an extra tax in addition to the standard duty rate.

On a £200,000 house or flat, this means the tax for buy-to-let investors is now £7,500 rather than the £1,500 charged to owner-occupiers.

In Scotland landlords need to pay an extra 4% on top of the Land and Buildings Transaction Tax on properties costing over £40,000.

In Wales you will need to pay an extra 3% in Land Transaction Tax on properties costing over £40,000.

On top of this, you will need to cover solicitors’ fees, surveys, as well as any extra charges related to your mortgage.

Your expenditure will increase if you use a letting agent to find and vet tenants, and perhaps also to manage the property.

Rental income

In general, your lender will require your rental income to exceed your monthly mortgage repayments by a quarter or a half. You will be able to get a good idea how much rent you can charge from looking at rates on similar properties in the area – but be aware that rental rates can fall as well as rise over time.

You may be able to get enough rent not only to cover mortgage repayments but also to generate a regular income for yourself, particularly if you can put down a large deposit.

Under current rules, the cost of the mortgage interest you pay can be offset against taxable earnings for income tax purposes, but the amount you can offset against has been reducing since 2017. From April 2020 tax relief will be restricted to the the basic rate of income tax (currently 20%).

Unexpected costs

Being a landlord comes with numerous responsibilities: it will be up to you to keep your property in good repair and to deal with problems such as flooding or a broken-down boiler.

Consider taking out landlord insurance so you are not hit with large bills out of the blue.

Capital gains

Landlords hope that rising property prices will help them generate significant capital growth. This has certainly been the case in the last couple of decades, but there is no guarantee that house prices will always increase.

Any profit you make when you eventually sell will be subject to capital-gains tax.

And bear this in mind too when you buy-to-let…

Buy-to-let is a business - not an investment or a hobby. It requires a clear insight into the property market, knowledge of rents, ability to deal with tenants, usually paying an agent and a clear business plan at the start.

It also needs faith that property prices will rise enough to protect against any losses and ensure a capital return when you need it.

Read our guide to becoming a landlord

Find out about Saga Landlord Insurance