BUY TO LET GUIDE - STRESSED INTEREST COVER RATIODANIEL MCLARDY
There is a common perception that a Buy to Let Mortgage simply requires the monthly rental income to be more than the mortgage payment. If only life and mortgages were this simple! In actual fact lenders use their Stressed Interest Cover Ratio to calculate if the property to be mortgage meets with their rental income criteria. Here’s how it works:
STEP ONE – INTEREST COVER RATIO (ICR)
Breaking it down, I’ll explain first what ICR means. ICR is the extent to which your property’s rental income covers the interest on the loan. To give an example, Mr Smith has a buy to let property and he has just applied for a £100,000 re-mortgage product at a fixed interest rate of 3.5%. The current tenants are paying £610 per month. Shamefully, I have my calculator on my desk right now and I’m using it. Let’s crunch the numbers. 3.5% of £100,000 is £3500 in interest per year versus rental income of £7320. As we can see, Mr Smith has the basics in his favour because the rent clearly exceeds the mortgage interest payments. But, as with all things mortgage we need a mathematical expression of how much the income covers the rent. This is the ratio part! If we divide the £7320 rental income by £3500 interest, we have 2.09. Voila! The rent covers the interest by 2.09 times. Looking good and the drinks are on Mr Smith, right? Hold your horses – read on
STEP TWO – STRESS RATE (the S!)
When Mr Smith applied for his re-mortgage product his application wasn’t assessed on the interest rate of the product he applied for. Of course not – this would just be too simple. The lender actually would have used a higher notional rate called the “stress rate”. The stress rate is a way the lender gives a margin of safety for possible adverse events in the future, with one (of many) concern being a significant rise in interest rates. His lender wants to make sure that such eventualities don’t hit Mr Smith so hard that he gets in to financial difficulties. This particular lender has a stress rate of 5%, so now we know this we can bring it all together
STEP THREE – PUT THEM TOGETHER
So now we need to crunch the numbers again with the lender stress rate. It’s £100,000 borrowing x 5% stress rate to arrive at stressed interest of £5000. That’s much higher than with the 3.5% actual rate he will be paying. The rental income of £7320 divided by £5000 of stressed interest gives the mortgage lender the figure they will be assessing, which is 1.464
GREAT! MR SMITH’S STRESSED INTEREST COVER RATIO IS 1.464. THE DRINKS REALLY ARE ON HIM!
It’s not as clear-cut as you might think. Mr Smith’s lender has a requirement for the Stressed ICR to come in at 1.45. He met the requirement for the mortgage, but by the skin of his teeth. Mr Smith made the cut, but it wasn’t as safe as he thought, and the only drink he’ll be having is a whisky to steady his nerves! Getting back to reality now, we also need to add an additional layer of complexity not mentioned in Mr Smith’s case, which is the fact that the ICR doesn’t use the rent the property currently achieves. It uses the rental value
STEP 4 – MAKE SURE YOUR CALCULATION USES RENTAL VALUE
The lender won’t base the Stressed ICR on the rent the property currently achieves, or what you think it may achieve. These can differ from the current rental value, which is determined by the lender’s surveyor or valuation team. In Mr Smith’s case we assumed that the lender agreed that the market value of his property’s rent was the same his current tenants were paying, being £610 per month. The point I am making is that on applying for a buy-to-let mortgage you need to be realistic about the rental income in the context of the current market . A shortfall could cause you disappointment
WHAT HAPPENS IF MY BUY TO LET PROPERTY DOESN’T SATISFY THE LENDER’S STRESSED ICR?
It may not mean that your application is declined outright. In many cases a lender will offer to lend you a reduced amount to bring the stressed ICR down to the required level. This can work if you have the money to bridge the gap, but with large SICR misses it can be too much money to find. A proportion of lenders allow an alternative route to address a SICR shortfall, called “top-slicing”. This is where the lender evaluates your personal income and other financial circumstances to gain an understanding that you could continue making the mortgage payment if events conspired against you. It’s important to reiterate, however, that not all lenders accommodate a top-slicing approach
WHAT DETERMINES THE LENDERS’ INTEREST COVER RATIO
At the current time lender ICRs vary between 1.25 and 1.55 (give or take) and this is influenced by their attitude towards risk (the general market), regulatory influences, and the circumstances of the borrower. A basic rate tax payer, for instance, can face a lower ICR requirement from certain lenders, as they may have a lesser tax burden associated to their rental income. Conversely, a higher rate taxpayer may face a higher ICR test for certain lenders
WHAT DETERMINES THE LENDERS’ STRESSED INTEREST RATE
At the current time we are seeing stress rates of between 5 and 6% (this is a very general overview), and again this is influenced by the lenders’ risk evaluations associated to the wider economy and market, as well as regulatory influences. In terms of personal circumstances, a lender may reduce the stress rate for a low loan-to-value situation. We have seen lenders reduce the stress rate requirement by 0.5 percentage points for loans below 65% of the property value. A lender may also reduce the stress rate if the product is a long term fix. We have seen lenders reduce the stress rate requirement by 0.5 percentage points for loans where the product is a 5 year fix or greater. This is because longer term fixed rates help mitigate the risk of interest rate rises, or general volatility
I HOPE THIS HELPS – BUT REMEMBER, A GUIDE IS A GUIDE AND NOTHING MORE
The above will hopefully improve your knowledge of Stressed Interest Cover Ratio , and how it relates to Buy-to-let mortgage transactions, but it’s by no means exhaustive, and my comments are acutely time sensitive. Lender policies and market conditions are forever changing
WE FEATURE OUR GUIDES TO ENRICH THE CONTENT AND INTEREST IN OUR WEBSITE. THE ABOVE, AND GUIDES LIKE IT, DO NOT CONSTITUTE ADVICE, AND THE ACCURACY OF ANY INFORMATION WITHIN IS NOT GUARANTEED
NOT ALL BUY TO LET MORTGAGES ARE REGULATED BY THE FINANCIAL CONDUCT AUTHORITY
YOUR PROPERTY MAY BE REPOSSESSED IF YOU DO NOT KEEP UP REPAYMENTS ON YOUR MORTGAGE
