How do buy to let mortgages work?

A buy to let mortgage is assessed on the property's earning power rather than on yours. A residential lender asks what you earn and what you spend; a buy to let lender asks what the property will rent for and whether that rent covers the interest with a margin to spare.

Three consequences follow. Deposits are larger, usually 25% and up. Most products are interest only, because that maximises the rental margin. And the amount you can borrow is capped by the rent rather than by an income multiple — so a property that rents poorly cannot be heavily geared no matter how much you personally earn.

This is the calculation that decides your maximum loan, and it catches many first-time landlords by surprise. The lender does not test the rent against the rate you are paying — it tests against a higher notional rate, and requires the rent to exceed that by a set percentage.

Example: a £150,000 loan tested at 145% of interest at a notional 5.5%. Notional annual interest is £150,000 × 5.5% = £8,250, or £687.50 a month. Rent required at 145% is £996.88 a month. If the property realistically rents for £850, the lender will cut the loan back to what the rent supports — around £128,000 here — and the gap has to come from a larger deposit.

Both the cover ratio and the notional rate differ between lenders, which is why the maximum loan can vary so much for an identical property. Basic-rate taxpayers are commonly tested at a lower ratio than higher-rate taxpayers, and some lenders apply a lower notional rate on five-year fixes.

Owning in your own name usually means a wider choice of lenders, lower rates and no company accounts — but mortgage interest relief is restricted to a basic-rate tax credit and rental profit is taxed at your marginal rate.

Owning through a limited company lets the company deduct interest in full as a business expense, with profits taxed at corporation tax rates and flexibility over when they are drawn. Against that, rates and fees are usually higher, there are annual accountancy and filing costs, and moving existing property into a company can trigger stamp duty and capital gains tax.

The crossover point depends on your marginal tax rate, how many properties you hold and whether you need the income now. It is a question for an accountant — the mortgage rate difference is usually the smaller half of the answer.

A yield that looks healthy against the mortgage payment alone can be thin once the full costs are in the model:

• Stamp duty surcharge on additional properties — rates and thresholds differ across England, Scotland and Wales, and change often.
• Letting agent fees if you use a managing agent.
• Void periods — the mortgage does not pause when the property is empty.
• Maintenance and compliance — gas safety, electrical checks, EPC requirements and deposit protection.
• Landlord insurance — standard buildings cover does not extend to let property.
• Income tax on rental profit, and capital gains tax on eventual sale.

Most buy to let mortgages are not regulated by the Financial Conduct Authority. A regulated mortgage broker can help you compare lenders' stress tests and criteria, and an accountant can advise on the ownership structure and tax.