Maintaining Interest Coverage Ratio and Stress Rates in Buy To Let Mortgages

• Buy To Let Mortgages
• 27th August 2024

Maintaining Interest Coverage Ratio and Stress Rates in Buy To Let Mortgages

The Buy-to-Let (BTL) market has undergone a seismic shift, moving from a period of robust growth fuelled by low interest rates to an era fraught with uncertainty. The current landscape is defined by high interest rates, the highest seen in over 15 years, and an unpredictable trajectory for the Bank of England's base rate. This volatility casts a long shadow over the sector, despite the UK government's and central bank's efforts to stabilize the market.

Investors now face a challenging environment, where securing a profitable BTL investment is no longer straightforward. The expiration of existing mortgage deals is likely to expose landlords to significantly higher rates, while lenders are increasingly stringent in their application of stress tests and Interest Coverage Ratios (ICR). These tests, designed to ensure that rental income can cover mortgage payments even if interest rates rise, are becoming a formidable barrier for many.

Understanding the intricacies of stress testing is crucial for landlords, especially if they are on variable rate mortgages. These tests determine whether the rental income generated from a property—or from an entire portfolio in the case of portfolio landlords—can withstand potential increases in interest rates. Lenders are scrutinizing these figures more closely than ever, making it essential for investors to have a clear picture of their borrowing capacity before proceeding with new investments.

In this new reality, the buy-to-let market is increasingly characterized by caution and calculated risk, as landlords navigate a complex financial landscape where the rules of engagement have fundamentally changed.

The stringent combination of ICR requirements and stress rates is creating formidable hurdles for BTL investors, particularly in regions like London, where rental yields hover around 2.5% to 3.5%. In contrast, areas like the West Midlands, with yields between 6% and 8%, offer more breathing room. For portfolio landlords—those with four or more properties—the challenge intensifies. Lenders assess the entire portfolio’s ICR collectively, adding a layer of complexity that can complicate financing across multiple properties.

Stress testing for buy to let – how does it work?

When lenders assess a Buy-to-Let mortgage, they focus on two key elements: the Interest Coverage Ratio (ICR) and the stress interest rate.What is ICR (Interest Coverage Ratio)?

The ICR measures how well the rental income covers the mortgage payments under normal conditions. Typically, rental income must cover between 125% to 150% of the mortgage payment depending on the product (asset type). For instance, if the mortgage payment is £1,000 per month, the rental income required could be between £1,250 for a vanilla residential BTL or up to £1,500 for semi-commercial properties.

Stress Rate

The stress rate measures how well the rental income covers the mortgage payments under stressed conditions and are applied depending on the rate format chosen:

• Fixed Rates: If you opt for a 5-year or longer fixed rate, the stress rate typically varies from 0 to 100 bps of the actual rate of the product, known as the "pay rate." This usually allows for greater borrowing capacity.
• Variable Rates: For product on variable rates, the stress rate applied will generally be higher than the actual interest rate of the mortgage at the time to provide for fluctuation in Central Bank rates which determine market interest rates. This can vary from 150 to 450 bps on the Central Bank rate or 100 to 250 bps on the Lender’s base rate which is usually at least 100 bps over the Central Bank rate. This ensures the lender's confidence in your ability to manage payments even if interest rates rise.
• It is important to remember that that ICR is a factor at the time of commencement of the loan whereas stress tests are usually taken annually, and therefore as circumstances change, the implications of a stress test can be very different from an adequate ICR.

Given this, borrowers may need to adjust their Loan-to-Value (LTV) expectations or explore more customized solutions. Specialist lenders, such as Novyy, play a crucial role in offering tailored financing options that align more closely with individual borrower needs and circumstances. These lenders provide a more personalized approach, addressing the specific challenges and goals of each client.