Buy-to-let mortgages

Everyone knows someone with a string of "buy-to-lets" that are designed to become their retirement nest egg. And the government is about to let us go the whole way and stick property into pension plans.

Much has been written about the buy-to-let mortgages that have allowed thousands of people to become property magnates, but anyone thinking of buying investment property needs to go back to basics and find out exactly what a buy-to-let mortgage will entail.

When did the buy-to-let craze start?

Property investment has always been with us, but mortgages for rented-out property traditionally carried surcharges and unattractive commercial rates of interest. Typically, investors paid up to 3 percentage points more on their mortgages than owner-occupiers.

Amazing as it may seem now, a decade ago buy-to-let property just wasn't on the radar as an asset class except among the seriously rich, and exotic foreign investors. It didn't have any relevance for ordinary investors.

Then, in September 1996, during the slow recovery from the property market doldrums, some enterprising types at several mortgage lenders teamed up with the residential letting agents' body (Arla) to woo investors and boost the lacklustre housing market with access to cheap and flexible mortgages.

According to the Council of Mortgage Lenders, the market is now worth some £63.5bn and there are currently 632,000 buy-to-let mortgages. That's 7 per cent of all residential mortgage lending.

How do these mortgages work?

The phrase "buy-to-let" is shorthand for investment in residential property, usually backed by a mortgage. The owner of the property pays the mortgage (which can run alongside their main residential mortgage), usually on an interest-only basis. Landlords can then rent out and manage the property themselves, or pay a fee to a letting agent, usually around 10-15 per cent of the monthly rental income. Either way, the landlord has to run the investment property as a business.

How much can investors borrow on a buy-to-let mortgage?

Unlike a normal residential mortgage (where most lenders assess how much they will lend according to the applicant's regular income), the size of a buy-to-let loan is usually linked to the expected rental income from the property.

Other income may also be a factor because lenders want to know that you are going to be able to meet your payments each month, and they will also check the rest of your finances (other mortgage payments and outgoings) to satisfy themselves that would-be investors can cover the shortfall if the property were empty for a few weeks or months.

Generally, the expected income from rent paid by tenants should be 125-130 per cent of the monthly mortgage payment. But different lenders have different rules about this. Some lenders will offer mortgages where repayments equal 100 per cent of rental income - leaving no margin at all - although the fees on these deals tend to be far higher. Borrowers will also need a cash lump sum deposit of at least 20 per cent of the purchase price.

Provided you have equity in your buy-to-let properties and the estimated rental income is greater than the mortgage interest repayments, most lenders will let you increase your borrowings to fund further buy-to-let purchases. This is how people who own a string of buy-to-lets keep refinancing them. Some lenders offer £5m mortgage loans to single investors who have remortgaged their property portfolios on the back of booming markets.

What sort of rates can you get on a buy to let mortgage?

Recently this has become an incredibly competitive market because demand from buy-to-let investors has fallen off in a slower housing market. The deals at the moment are almost indistinguishable from the residential rates.

Three and five-year fixed-rate deals are on offer at less than 5 per cent, although the set-up fees on buy-to-let mortgages tend to be high, running to several hundred pounds. Check websites such as moneyfacts.co.uk and charcolonline.co.uk for latest buy-to-let rates.

How do you put a mortgaged buy-to-let property into a pension?

Owners will have to pay to transfer the property into a pension (that means paying stamp duty again, and possibly capital gains tax). Then the buy-to-let mortgage will be swapped for a Sipp mortgage.

According to independent mortgage broker Savills Private Finance, lenders haven't yet announced how they plan to develop Sipp mortgages, although it expects them to be offered by many of the same lenders that currently have buy-to-let deals.

It will be up to the Sipp provider to negotiate a mortgage deal because once investors put their property into a pension it is then effectively owned by the pension trustees. This means the Sipp provider is likely to appoint a managing agent, and the rental income from tenants will be used to pay the mortgage.

Investors can at any time decide to sell a buy-to-let property held in their pension, and pay off the mortgage, and instruct the pension trustees to do just that. The big snag is that pension holders won't be able to get hold of any profits from the sale until they are at least 50 - the money has to stay in the Sipp until then - although they will be able to use the proceeds from any sale to invest in other assets within the wrapper of their pension.