Rental income of €1,600 per month on a property valued at €400,000 equates to a gross yield of 4.8%. However, if you account for all costs, actual and imputed, the property is unlikely to achieve a net yield of more than around 3.5% per annum, on average, before financing costs and income tax... A net yield of 3.5% is less than the cheapest variable rate mortgage currently on the market so financially it makes more sense to sell the rental property and take out a smaller mortgage on the new property.
Not sure this is the right way to look at it. Only €200k of the value of the investment house belongs to the OP. The rest is borrowed at an incredibly low rate of under 1%. A return of 3.5% on this portion is pure profit, which cannot be translated over to the other mortgage since the tracker is not transferable. I think the only fair way to look at it is the net effect of leaving the OP's €200k where it is, or moving it to the other mortgage. Also, in counting financing costs, only the interest portion of the mortgage on the investment property should be counted, i.e. 1% of the outstanding €200k, or whatever it is. The rest is paying capital. I agree he should look closely at his income tax which might erode the value of the investment significantly.
Ok, look at it this way so:
Ignore income tax for a moment and let's say you have €200,000 in cash. Would you chose to use the cash to pay down a mortgage of €200,000 at a fixed-rate of 4% per annum over a particular period or would you buy a bond that pays a fixed coupon of 3.5% over the same period? Ignoring liquidity considerations, you would obviously pay down the mortgage. Now let's say the source of that €200,000 in cash is a loan at an incredibly low rate - 0% for example - would that change the decision?
Now let's say income tax reduces the after-tax yield on the bond by, say, 50% to 1.75%. I would suggest that paying down the mortgage now becomes the very clear winner.
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