Savings And Investments Mark on 05 Jun 2008 08:22 pm
How Falling House Prices Increase Buy-to-Let Mortgage Risk
John’s article House Prices Really Are Falling got me thinking, and I posted a comment about the effect this would have on re-mortgaging, particularly with buy-to-let investors in mind. In the search for financial freedom, buy-to-let investments are well known as an instrument for creating passive income, and/or increasing the value of capital (by utilising the appreciation of the value of property). With this in mind this article highlights one of the (less obvious?) risk in the buy-to-let investment market. I will start with a short summary of how how mortgaging and re-mortgaging is used as an instrument in this kind of investment. I will then go on to give some sample figures illustrating how things can go wrong and what the damage might be.
Typically, mortgages can be obtained with a reduced rate for the first two years, and this is something investors rely on in as part of their business model. Also, with the reduced rate comes with a heavy financial penalty for redeeming the mortgage early. After the two years has elapsed, the interest rate goes up significantly. Therefore it is normal - and normally necessary - to re-mortgage every two years. Further, it is prohibitive - because of the heavy financial penalty - to re-mortgage before the two years is up.
Therefore, the expiry of the two year fixed rate is a point of risk in the business model of the typical buy-to-let investor. The point is this: because BTL mortgages are almost always interest only, the investor needs the new mortgage to pay off the capital on the old one. Also, how much you can borrow is directly linked to the value of the property. That is to say, when you re-mortgage, the amount you can borrow is a percentage of the new (fallen) value of the property.
What I’m going to do now is present an illustration that assumes the following:
- The value of the property when originally purchased was £200,000
- After two years the property value has fallen (by 8%) to £184,000.
- When re-mortgaging, the investor can borrow a maximum of £156,400 (that is, eighty-five percent of the fallen property value)
I have fixed the amount that can be borrowed when re-mortgaging, in order to show how the shortfall varies depending on what percentage of the original purchase price was actually borrowed. Also, I am assuming that eighty-five percent of the property value can be borrowed when re-mortgaging, and I have ignored arrangement fees.
- Amount borrowed for purchase (90%): £180,000 => £23,600 shortfall
- Amount borrowed for purchase (85%): £170,000 => £13,600 shortfall
- Amount borrowed for purchase (80%): £160,000 => £3,600 shortfall
- Amount borrowed for purchase (75%): £150,000 => £6,400 excess
Therefore the prudent investor who only borrowed seventy-five percent of the property price when the market was buoyant can withstand the eight percent drop in the property value. This investor will be left in the clear by £6,400! Note in passing, that this investor could actually withstand a fall of just under twelve percent in the property value and still break even.
Sadly not all BTL investors have had the prudence to allow for a fall in prices. I suspect that, sadly, there were many investors who bought into the by-to-let market without even realising they were exposed to the risk I have illustrated in this article.
on 06 Jun 2008 at 4:23 pm 1.Tristan said …
Good article Mark, there are probably a few mortgage brokers that have advised clients to buy investment property that don’t realise the risks themselves, let alone able to communicate them to their clients.
I have a few clients that have BTL properties, I have always recommended that they look at three year deals, usually fixed, but in some instances (usually where the LTV is low) I’ve recommended they go for a tracker, having explained the risks of course.
An interesting point that I’m not sure you really emphasized in the article, is that some novice BTL investors bought properties that they couldn’t really afford, on 1 year mortgage deals, hoping that the property value would rise over the following 12 months and then enable them to re-mortgage onto a better deal as the LTV would have decreased…in theory.
I actually had an enquiry like this recently, and after doing my research, I wasn’t able to find the prospective client a mortgage, as the property had in fact fallen significantly in value. So they now have a property worth less than they bought it for, costing more in interest each month than they receive in rent, not the best investment all round really.
on 08 Jun 2008 at 6:34 pm 2.Mark said …
Thanks for the comment Tristan, and I take your point about people buying property they couldn’t really afford; it’s a situation that the article covers implicitely, but doesn’t really emphasise whereas it could (and probably should) have.
I think the underlying problem is that BTL investing has been seen (by some) as something of a “free lunch” whereas, in reallity, it has its risks like any other investment opportunity!