My portfolio contains 3 buy to let properties that are rented out. Each property has a mortgage on it which over the years I have paid down to some extent. However I have been facing the time honored buy to let issue: when should I pay down the mortgages on my buy to let properties?
The ‘problem’ is that I am currently a higher rate (40%) tax payer. My financial/retirement plan dictates that at some point in the future the day job will be shelved (or maybe it’ll shelve me) and I’ll be living off the fruits of the money tree. As a result I have two main financial priorities:
- Minimise my current income tax bill
- Maximise my investments that will provide future income
In order to minimise my income tax liability I aim to not make a monthly profit on my buy to let properties. If the rental income exceeds the allowable expenses (mortgage interest, repairs and legal fees being the main ones) I have a tax liability on this amount. In other words I pay 40% tax on any income related profit the properties make.
As a result I am incentivised not to overpay the mortgages too much and to leave them at a state where the monthly mortgage interest (which is a tax deductible expense) is roughly equal to the rental income.
I will only pay off the mortgages only when I need the income they produce. The Buy to Let trap I am currently in is how and when to pay them off. Lets have a look at my options:
1. Use My Current Income
As described above, any increase in my net income as exposes me to a 40% tax liability. Therefore on the face of it it makes sense to keep the mortgage high and invest the money I would have used to reduce the capital elsewhere.
2. Save the capital in an ISA
The obvious answer to the problem would be to use ISA accounts (and their tax free benefits) to save the capital to repay the mortgage at a future date. At some point in the future (when I need the income the properties produce) I can use these ISA savings (and any gains they’ve made) to pay off the mortgage debt.
The big problem I have with this option is that I want my cake and to eat it too. The tax free income my ISAs produce is not something I want to give away. That tax free income is a big part of my retirement plan and a core foundation of the money tree. I want to do everything I can to keep the capital invested in the ISAs and maximise my future tax free income.
3. Save Outside of ISA
At the time of writing I could tuck away some cash (ear marked for the mortgages) in a 5 year fixed rate savings bond that would yield 3.25%. The only problem is that [for any investment] outside a tax wrapper, this yield drops down to 1.95% once I factor in my tax rate. This net yield then is less than the cost average APR of the outstanding mortgages (not to mention inflation) so again I’d be throwing money away.
4. Use My Pension
The only solution that seems to tick all of the boxes is to make any savings earmarked for mortgage repayments into my pension pot. I can then use the 25% tax free lump that I’ll be able to take out of my pension upon retirement to pay down the loans.
By using this approach any ‘savings’ I make and mentally allocate towards paying off the buy to let loans are sheltered from tax. In addition I’ll benefit form the tax relief on pension contributions and the relative freedom to invest these ‘savings’ as I see fit.
Of course, as with any financial strategy, there are risks. I need to carefully consider the following points:
- When I retire I may not be able to rush out and buy a sports car!
- Will 25% of my pension pot at retirement will be enough to pay off the outstanding balances?
- Will income draw down on 75% of my projected pension pot provide me with enough income in retirement?
- If interest rates rocket back up (unlikely as it may seem in the short term) my ability to pay off capital will be locked up in a pension fund where I won’t be able to access it until retirement.
- Are the loans due to be repaid before I retire?
I’m quite heavily exposed to property in my portfolio with 3 buy to lets. I can’t see how/why the demand to rent properties in this country is ever going to fall significantly (limited supply + increasing population) so the future income they produce appears to be safe.
My strategy is a buy and hold one so their values (and property prices in general) aren’t really a concern to me. The biggest risk I am therefore running on this part of my portfolio with this strategy is the interest rate risk. This risk is partly hedged by my cash holdings and for the time being at least I’m willing to run the remainder of this risk…..