Refinancing a portfolio: when to pull equity out and when not to
Pulling equity out of one property to buy another is the standard growth mechanism. It is also the point at which many portfolios become fragile.
The mechanism is straightforward. If a property has risen in value, you can remortgage it at a higher loan-to-value and take the difference as cash, which becomes the deposit for the next purchase. The original property still pays for itself; the extracted equity funds the growth.
What is less straightforward is the arithmetic of whether it improves your position. Every pound of equity you extract is replaced by debt that carries interest, and the new property has to earn more than that interest for the manoeuvre to add anything.
The test to apply
Compare the net yield on the property you would buy against the interest rate on the debt you would take on. If the net yield exceeds the borrowing cost, leverage improves the return. If it does not, you are borrowing to reduce your return, which is a strange thing to do deliberately.
The comparison must be on net yield, not gross, and on the actual rate, not the headline one. This is where Section 24 matters, because a higher-rate taxpayer receiving only a 20% credit for mortgage interest is effectively borrowing at more than the quoted rate.
- Net yield on the new property, after all costs and voids
- The actual interest rate, including any fee amortised over the fixed period
- The tax treatment of the interest, which for an individual is worse than the headline rate
- The effect on your overall loan-to-value, and therefore on the rate available at the next refinance
- Whether the new property's income covers its own debt, or whether it is subsidised by the portfolio
The costs of refinancing
Refinancing is not free. There is an arrangement fee, a valuation fee, legal costs on some products, and an early repayment charge if you leave a fixed deal before it ends. There is also the risk that the valuation comes in lower than you expect, which reduces the equity available.
The early repayment charge is the one that catches people out. Leaving a five-year fix in year two can cost several per cent of the loan, which frequently exceeds the benefit of the refinance. The time to plan a refinance is at the end of the fixed period, not during it.
When not to extract equity
There are two situations where leaving the equity alone is the better decision. The first is when the new property does not clear the yield-versus-rate test. The second is when extracting equity would push your portfolio's overall leverage to a level where a rate rise or a void would put you under pressure.
The stress to apply is: if rates rose two percentage points and one property was void for three months, would the portfolio still cover its costs? If the answer is no, the portfolio is fragile, and adding debt makes it more so regardless of what the yields say.
Common questions
- How much equity can I release from a rental property?
- It depends on the lender's maximum loan-to-value for buy-to-let, commonly 75% and sometimes 80%, and on the property passing an affordability check on the rent. If the property is valued at £200,000 and you have a £100,000 mortgage, a refinance to 75% LTV would release roughly £50,000 before fees.
- Is it worth remortgaging to buy another property?
- Only if the net yield on the new property exceeds the interest rate on the additional debt, after accounting for your tax position and all the costs. If it does, leverage increases your return. If it does not, you are taking on risk and work in exchange for a lower return, which is worth recognising before rather than after.