Almost every Landlord I know has debt. It’s that big fat thing called a Mortgage, whose monthly payments probably wipe out half of your rental income each month.
Im not going to argue today whether mortgage debt is good or bad. The answer to that is something that will be specific to each Landlord based on their personal preferences, mortgage terms (interest rate, term etc) and how it compares to the value of the property and rent you receive. Although if you want my opinion:
“I see mortgage debt as good. It facilitates me running my property business”.
Instead, I want to talk about something accountants and other fancy Finance people call a “stress test”. And how Landlords can and should apply this test to their Mortgage debt.
Seriously? Are you just making this up?
Trust me, its a real thing. Let me start with a Wikipedia definition of a “stress test”:
“A stress test, in financial terminology, is an analysis or simulation designed to determine the ability of a given financial instrument or financial institution to deal with an economic crisis. Instead of doing financial projection on a “best estimate” basis, a company or its regulators may do stress testing where they look at how robust a financial instrument is in certain crashes, a form of scenario analysis.“
That sounds complicated. What does that really mean?
Put simply and applied just to property debt (aka mortgage), a stress test calculates the financial impact of possible changes in your mortgage payments. Time to get number crunchy.
Let’s say for example your monthly mortgage payment is £1,060. That’s based on a 20 year capital repayment mortgage of £200,000 with an variable interest rate of 2.5% (base rate + 2.4%). Rent is £1,400 and other costs are £140 so monthly profit is £200.
Now, here’s the stress test part. You just need to ask yourself a few questions to test out possible scenarios and then calculate the impact. Something like:
- What happens if interest rates go up by 1%? (A: Mortgage payments become £1,160, monthly profit becomes £100)
- What happens if interest rates go up by 2%? (A: Mortgage payments become £1,165, monthly profit becomes a £5 loss!)
- What happens if interest rates go up by 5%? (A: Mortgage payments become £1,611, monthly loss of £351 – ouch!)
How do I calculate this impact?
Easy. Use one of the many free online mortgage calculators and simply enter the number. Here’s one link you could use:
https://www.moneysavingexpert.com/mortgages/mortgage-rate-calculator/
Would interest rates really go up by 5%?
Probably (hopefully) not. But they could do. More likely is that it will go up by say 1%. The good new is that the stress test is not trying to predict the likeliness of each scenario. Instead you are just checking the impact on a few different potential scenarios. So no need to try and apply weighting to the answers based on likeliness of occurrence, or anything complicated like that.
Ok fine. That’s pretty easy then. What do I do with the results?
1) Firstly, check how much buffer you have for adverse movements:
– If even a tiny rise in interest rates results in you making a monthly loss – you don’t have much wiggle room – time to start planning for this (ACT)
– If you feel you are pretty well covered for a rise in interest rates – thats great. You can sleep easier knowing you are in control of your finances. (still worth reading point 2 below though)
2) If you need to ACT – do it, and do it now:
– Its time to look at how to make your property more profitable. There are many way to do this (yes, yes, its coming in future blog posts) but the business as you are running it now has too much risk for the returns you receive
– Buffer up. Put money aside. Rainy day fund. Call it what you like. You need to put money aside regularly to protect yourself for any future movements.
I’m on a fixed rate mortgage so this doesn’t impact me does it?
Correct. Sort of. For now a change in interest rates won’t impact you. But unless you have a lifetime fixed rate at some point you will need to remortgage, and then you will move to a new interest rate. How will that impact your overall property profits? The stress test above will tell you that.
What’s more, I’m just looking at mortgage debt here. But you can go further and stress test more than your mortgage debt. You can calculate how your property finances would be impacted if, for example:
- What if my tenant defaults and doesn’t pay rent for 6 months?
- What if the property requires £10,000 of major refurbishment work that isn’t covered under insurance?
- What if there is a major global flu / virus outbreak (surely this would never happen?) which causes rents to plummet 50%?
Get creative (Accounts like myself struggle with that). Think of some possible terrible scenarios. Then think how that would impact your property finances. What fun!
So to conclude
I’d recommend that Landlords stress test their mortgage debt payments. You don’t need to obsess over the results (as they are just future possible scenarios) but it’s important to have an idea how these might impact you. You can then plan and prepare accordingly should the scenarios ever play out.
Don’t let debt stress you out. Take control of that debt stress by understanding it and then using that knowledge to plan accordingly.