What Is Interest Coverage Ratio in Buy To Let?

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The buy-to-let landscape has undergone substantial shifts, marked by a transition from a thriving housing market and low interest rates to an environment fraught with uncertainty. The trajectory of the bank base rate remains uncertain, alongside challenges regarding property cost fluctuations. While efforts from the UK government and Bank of England aim to inject stability into the market, the aftermath of these changes manifests in the current buy-to-let scene.

As investors pivot towards securing their next buy-to-let investment, they encounter a new array of challenges previously uncharted. The prevailing environment presents some of the highest interest rates witnessed in over a decade. Moreover, existing buy-to-let mortgages are poised to escalate once their current rate terms conclude. Lenders’ increased emphasis on stress rates and Interest Cover Ratio (ICR) further compounds the hurdles landlords face in navigating prevailing market conditions.

The complexity of loan affordability is on the rise, requiring a holistic perspective on buy-to-let mortgages. Ideally, rental income should encompass mortgage payments, interest, and property expenses, leaving room for profit. However, lenders factor in safety nets within their product ranges to ensure rents cover mortgage payments adequately, facilitating loan repayment. Concurrently, lenders exercise a duty of care towards borrowers by offering mortgages that remain affordable amid market fluctuations. These stringent parameters underscore lenders’ commitment to ensuring borrowers and loans meet stringent affordability criteria, safeguarding the interests of all stakeholders involved.

What is the definition of Interest Coverage Ratio (ICR)?

The Interest Coverage Ratio (ICR) is a crucial metric for landlords, determining their ability to cover mortgage payments on buy-to-let properties. It compares expected monthly rental income to the “stressed” monthly interest payment, factoring in potential interest rate hikes. Essentially, the ICR gauges affordability by evaluating whether rental income can sustain mortgage interest costs.

In other words, whether the rental income to be earned from the property will be enough to support the monthly interest cost of the mortgage payments using an interest coverage ratio (ICR) test. Mortgage lenders use the ratio to assess the resilience of the landlord’s portfolio to increases in interest rate.

The PRA Underwriting Standards for Buy-to-Let Mortgages for landlords

In September 2016, the Prudential Regulatory Authority (PRA) of the Bank of England issued rules for calculating the minimum ICR in Supervisory Statement SS13/16, Underwriting standards for buy-to-let mortgage contracts.

The standards stipulate that lenders must assess rental demand and typical rent levels within the property’s locality, verified by an independent qualified valuer. This valuation can employ methods such as automated valuation models or evidence of existing rental agreements, subject to appropriate policies, controls, and risk management.

What do lenders take into account in ICR calculation for buy to let mortgages?

Lenders have flexibility in determining the minimum ICR threshold.
The PRA advises considering various costs borne by the borrower:

Management and letting fees
Council tax, service charge, insurance
Repairs and voids
Utilities, gas and electrical certificates
Licence fee and ground rent
Other costs associated with renting out the property

How does a landlord’s tax rate affect the stressed ICR?

Previously, lenders required a minimum ICR of 125% using a stressed interest rate for buy-to-let landlords. This reflected the gross rental income needed to cover mortgage repayments, taxes, and maintenance costs, factoring in potential interest rate increases.

Changes to Mortgage Interest Tax Relief (MITR) from 2017 to 2020, known as Section 24, restricted landlords’ ability to offset full mortgage interest payments against rental income for tax purposes. Consequently, higher-rate taxpayers faced increased tax bills and required more rental income to break even, leading to higher stressed ICR thresholds.

Acceptable stressed ICRs now typically range from 145% for higher-rate taxpayers to 165% for additional-rate taxpayers. However, these ratios vary by lender; for example, The Mortgage Works applies a stressed ICR of 125% for basic-rate taxpayers and up to 175% for certain scenarios as of March 26, 2024.