Interest Rate Time Bomb
I was watching ‘How to beat tough times’ on the BBC the other day. This programme about the down turn; highlighted the financial perils we all face. It concluded that many people, including landlords have been saved from financial melt down by the historically low interest rate of 0.5%. The lowest for 400 years.
Clearly this can’t last.
The problem for many buy-to-let investors is that they are caught in a trap. The fall in the capital values of some of their property investments have left some landlords with little or no equity in their buy-to-let portfolio. Therefore; whilst they are sitting pretty at the moment. The inevitable rise in the base rate will tip them over the edge.
This means when interest rates do start to move up (some experts predict that this could happen as soon as Autumn this year – read more ) then the positive cashflow disappears and these landlords are suddenly having to finance their investments from other sources or risk losing their property.
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Problem compounded by increased margins
This problem faced by many landlords has been compounded by the restriction in the credit markets. This has resulted in substantially increased lending margins being charged by mortgage lenders; this has jacked up the ‘real’ costs of lending for all borrowers including landlords. During the pre- credit crunch days; the margin on a typical buy-to-let mortgage would be of the order of 1% or even less over base. Now it’s more likely to be 3-5%. This means that unless lending margins fall; a base rate of only 3% would lead to the average interest rate on a buy-to-let mortgage being of the order of 6-8%. Historically, base rates have been nearer 6%. This is all pretty scary news for all those highly leveraged landlords out there.
An example of the implication of this is that a landlord with a £100,000 obtained on a pre- credit crunch tracker. My rate at the time with Mortgage Express was a tracker rate of 0.39% above base. This equates to a monthly payment of £74. Where a pre-credit crunch tracker has lapsed; a mortgage lender will be moved to ME standard variable of 2.25% above base. This equates to an interest rate of 2.75% or a monthly interest payment of just shy of £230. If interest rates only go up by 3% over the next couple of years interest charges will more than double to 5.75% or £479 per month. A further rise to the long-term average base rate of 6% would lead to a rate of 8.25% or a payment on the same £100k mortgage of £687.50. This could result in a near 1000% increase in the costs of borrowing for some landlords.
The alternatives for landlords
One option for a landlord is to safeguard themselves against rising interest rates is to make over payments to their mortgage account in an attempt to reduce their debt and ultimately reduce their interest payments. Many mortgage lenders have waived over payment restrictions and now allow and even encourage borrowers to do this without incurring charges.
The other option is to opt for a repayment BTL mortgage. This traditional form of lending fell out of favour for many landlords during the rip roaring ‘noughties’ when gearing up was the name of the game. However, with interest rates inevitably likely to go up not down & capital appreciation less certain. Paying down a loan with strong cashflow could be the safest way to go.
New alternative product
The other alternative for a landlord who doesn’t wish to swap to another mortgage product but who is concerned about their exposure to rising interest rates could be a new financial product being marketed by Charcol Mortgages. It works like an insurance policy but is actually a financial derivative. It effectively allows a landlord to cap the base rate charged on all their mortgages. The downside is that it’s only available for loans of £500,000 or above, but this relates to total loan value not individual loan size.
The cap fee which has to be paid up front will ‘insure’ a landlord against future excessive rises in base rates and this can be done for any period from a single year to 10-15 years into the future. Given that rents have remained largely stable and are in fact, starting to rise again.
The ability to manage the major cost of most landlords which is their finance costs could help to steady future cashflows and guarantee that their business remains profitable even when interest rates rise.
The costs of new product
The minimum cover which can be purchased is £500,000 and the unit cost falls as the loan size increases. For example, a five year cap to cover a £500,000 mortgage currently costs approximately £16,500 for a cap at a 3% Bank Rate, £13,500 for a cap at 4% and £11,500 for a cap at 5%. Cover for a £1m mortgage would be approximately £28,000, £22,000 and £18,000 respectively.
Ray Boulger of John Charcol explains:
“If Bank Rate rises above the chosen level, monthly payments to cover the difference between that level and Bank Rate will be made either until the end of the insured term or until Bank Rate falls back below the chosen level. Anyone considering buying a cap needs to take account of the margin above Bank Rate or Libor they are paying on their mortgage when deciding at what level to buy the cap.
For example if their mortgage is at Bank Rate + 0.5% and they buy a cap with a reference price for Bank Rate at 3% the cap will start paying out when their mortgage pay rate is 3.5%, i.e. the 3% Bank Rate + the 0.5% margin above Bank Rate for their specific mortgage. Buying a cap may have tax implications, which will vary depending on the tax status of the purchaser(s), and so we strongly recommend all purchasers should seek specialist tax advice.
Property Hawks view
The coming years will present a big challenge for many landlords and one of the biggest is how to manage a rising interest rate and increased loan charges. The mortgage cap provides a way of managing this by potentially flattening cashflows and reducing future costs out of current expenditure.
Many other businesses employ the practice of hedging against future changes in a business environment & this product is a useful option for larger portfolio landlords to do exactly that.
Alternatively, a landlord could invest in a piggy bank and just put away their rental profits now ready for the inevitable rainy days.