Ultimate Guide to Financing Rental Property
11 Mar 2019 - Peter
If you want to become a property investor or landlord, one of your first steps is to finance your rental property. Even experienced landlords can find the alternative financing options complicated, so we’ve written this essential guide to help you get started.
Option 1: Traditional Buy-to-Let Mortgages
If you have a deposit available, the traditional buy-to-let mortgage is a simple way to finance new rental properties. Traditional buy-to-let mortgages are much like a standard occupier mortgage, with three main differences.
Firstly, your mortgage provider will take forecasted rental income into account. Since 2017, legalization has been passed which requires that the rental income will cover the interest on the mortgage by a margin of typically 145%, at a stress-test interest rate of 5.5%.
Put simply, you’ll need £100 of rental income for each £15,000 you intend to borrow.
- If you are buying a property for £120,000 and wish to borrow £100,000, your rent must exceed £572 p/month.
However, there are 3 exceptions:
- Lower Margins: With the right broker, it is still possible to find mortgages that require a 125% margin and a lower stress-test interest rate.
- Exceptions: These rules do not apply to mortgages for limited companies, bridging lending, commercial property, holiday lets or loans which have a fixed term of longer than 5 years.
- Portfolio Landlords: If you are a portfolio landlord (someone with four or more mortgaged properties), you’ll need a lot of documentation to get an additional traditional mortgage. For example, you could be asked to show the lender projections of your cash flow, your income and expenditure, your business plan, 3 months bank statements, your tax overviews from HMRC and even the tenancy agreements from all your properties.
Secondly, the mortgage will typically be more expensive than an occupier mortgage, with a higher interest rate and greater fees required.
Finally, you’ll require a 25% deposit as a minimum. This can come from a variety of sources:
- Borrow against your home: Some mortgage providers will allow you to borrow against your home in order to invest in a rental property. However, as you are taking more debt on your home, you’ll need to have an income sufficient to support this.
- Borrow a deposit: Terrible ideas we do not recommend include using credit cards or short term loans. Much easier to borrow from a relative
- Invest with friends: Ask friends and family to invest in you. Be sure to consider this option carefully and research legal options - a bad investment is the quickest way to sour a relationship.
- Side hustle: My personal favorite. Take photographs, build websites, clean houses - whatever it takes to save your first deposit.
Option 2: Bridging Finance
Bridging finance is a lot like a mortgage, but with some key disadvantages:
- Term: The term on bridging finance is generally 12 months or less
- Interest: The interest is usually much higher than a mortgage - 8%-15% at the time of writing.
- Charge: Tricky to understand, but usually the lender ‘takes charge’ over the property to secure the loan. This means you can’t sell or raise further money against the property without the approval of the lender. It also means they can force the property to be sold if you can’t repay.
Yet, bridging finance can be a powerful tool:
- Income: Generally, bridging lenders will not test your income or the rental income. You can get bridging finance with a low income. As it’s a short term loan, lenders don’t mind about the income you could produce over a long timespan.
- Property Condition: The condition of property generally doesn’t matter on day 1 - until it comes time to revalue the property and repay the loan.
- Quick: Bridging finance is quick to arrange, typically sorted within weeks (or even days)
Considering these factors, bridging finance only makes sense in a few circumstances:
- Short-term: You don’t want to hold onto the property for very long. For example, if you are flipping a property (refurbishing it to increase its value), bridging finance might be right for you. Simply use bridging to increase the value, then take out a new mortgage based on its newly refurbished value. Some lenders will even offer bridging loans based upon Gross Development Value (GDV) – this means they will offer a loan based upon what the property will be worth once you’ve completed your planned works on it.
- Speed: A seller might offer a discount to someone who can complete quickly after an auction. Bridging finance will complete much quicker than a mortgage.
- Non-Mortgagable: If a property cannot be mortgaged, as it is not habitable, you could take out bridging finance, get it habitable, then get a mortgage.
See our interview with Simon Murphy below for more details on bridging finance. Always speak to a financial advisor (we like Simon at Fenton Simpson) before making decisions like this!
Option 3: Get Creative
There are several more ‘creative’ ways to fund a property purchase. For all of these, do speak to a financial advisor before proceeding:
- Recycle your Money: If you already own property, getting a higher valuation for it, then releasing the value will release funds. There are 2 ways to do this - buy it for ‘below market value’ or add additional value. For example, you buy a property for £90,000, spend £10,000 improving it to be the same as the house next door – which you know is worth £135,000. You could also do other things to increase the value, such as extending the lease, resolving a legal problem….get creative in finding value!
- Joint Ventures: Team up with a wealthy investor or an experienced builder
- Crowd Funding: Various P2P and crowdfunding platforms now exists, which allows tens or hundreds of investors to buy a share in a house.