Financing a Second Home Mortgage
When it comes to financing a second home mortgage, there are many other options that you could consider to ensure that you make the best possible choice.
As with a standard first mortgage, you will discover that there is the usual question of whether the best mortgage is interest only or capital repayment. However, with a second home, you will also have other personal decisions to make when selecting the best option.
Interest Only v Repayment
This is an interesting debate! Traditionally, it has always been thought best to try to pay off the mortgage as quickly as possible to reduce the monthly payments. Arguably, this might be true of the main residential property, but with a second property there may well be other issues that require consideration.
A long-term investor who intends to keep the property for a decade or more and is planning to use the capital gain as profit at the point of sale in the future could argue that the more they can pay off of the mortgage the better. This is because the mortgage is acting as a savings plan, meaning that there will be greater equity available at the point of sale.
Of course, this only works if the investor has sufficient monthly means to meet the mortgage or if the rental income is particularly favourable.
Many lenders now look at affordability rather than strict analysis of rental income against mortgage. This means that they also take into account your ability to top up the mortgage payments from your other income. Typically, this approach is only really appropriate for those investors who have a large current income and are truly saving for the future.
For those who require a regular income (or at the very least cannot afford to 'top up' payments), then an interest only mortgage might be a better option as this ensures a minimum payment only, allowing you a better chance of achieving a profit on a monthly basis. However, this means that, at the point of sale, there will be less equity and the only capital gain will be the amount by which the property's value has increased. With this approach, there is even a danger that the value of the property will have fallen and the sale price achieved may not even be able to pay back the mortgage.
A second home that is for investment purposes will potentially be subject to multiple different taxes which, if not planned for, can turn a very lucrative profit into a substantial loss. Bear in mind that not only will you have the capital gains tax element to deal with on sale, but there are also regular taxation issues with rental income which have to be dealt with, immediately.
It is absolutely essential that these taxes are planned for as early on as possible, ideally before the sale is even completed; tax planning methods exist that can be used from the very beginning which will assist you in the long-run. Always make sure that you speak to an accountant or tax advisor about your individual circumstances.
Any income that you receive from a rental property should be disclosed to the Inland Revenue. Technically, this means that any income you make on the property will be taxable at the rate at which you pay income tax on your other income from your standard employment.
From the income that you obtain from letting a property, there are some allowable expenses which can be deducted. Typically, these expenses include rates, insurance and administration costs. Importantly, with a mortgage on a second home, interest paid on a loan can also be claimed as an expense. Therefore, the interest part of any mortgage on the second home can be deducted from the income, reducing the rental profit that is taxable.
If a property is furnished, you are also able to add expenses of up to 10 percent of the net rental profits for wear and tear replacement.
A second home that is sold and is not the main residence of the owner will be subject to capital gains tax of 40 percent. This can have a serious impact on the profit made from the second property and can even mean that you do not have sufficient capital available to repay the second home mortgage.
Capital gains are not payable on the main residence, and those who own more than one property can ‘elect’ which property is to be considered their main residence within 2 years of purchasing the second property. Capital gains is a difficult and complicated process but, in short, tax will only be payable on the time that the property was let and if the property was once a main residence; the last three years of ownership will also be exempt. Currently, there is also an allowance of up to £40,000 for this capital gain.
Example: an individual purchased a flat for £100,000, lived in it for 1 year before renting it out for the last four years and is now selling the flat for £200,000. The gain per year is, therefore, £20,000 (there would be some deductions such as any capital improvements that were made as well as the cost of purchase and sale, but for the sake of ease of calculation these have been ignored). The first year is exempt and the final 3 years are also exempt as it was once a main residence. Therefore, there is only 1 year on which capital gains are due. As this is only £20,000, the £40,000 allowance amply covers this gain and no tax is due.