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In an effort to stem the perceived risk of Buy to Let on the housing market, the Bank of England have imposed new guidelines on lenders to tighten underwriting standards that have slackened since the credit crisis.
Although there are no hard and fast criteria rules the Bank of England want lenders to stress test new Buy to Let mortgages assuming a minimum pay rate of 5.5% as opposed to any current historic lows.
Stress tests assessing affordability will also need to include the Landlord’s costs of letting the property and tax liabilities in doing so.
They have predicted this will affect at least a quarter of the Buy to Let lenders who will have to increase the rates at which they stress test new loans. Typically a loan is stress tested so that the rental income must cover at least 125% of the interest payments at a notional rate, which can be the same as the pay rate, but often not.
The PRA said,”Risks stemming from domestic credit have risen and it remained alert to potential threats to financial stability”.
The Bank of England expects these new measures to decrease the level of Buy to Let lending by a figure between 10% and 20% over the next two years.
The effect of these new guidelines will mean that lenders may have to increase the notional rate to a higher level to cover a possible increase in Bank Base rate. Therefore the rental income will have to cover a much higher figure at 125% and in addition have letting and tax costs taken off the rent before it is multiplied to cover the stress testing.
A hypothetical example of pre and post underwriting changes could be:
£500 rent pcm at a notional rate of 5% and 125% interest cover would cover a mortgage of £96,000
Now if the notional rate was increased to say 5.5% and 20% was taken off for costs then the same rental income would only cover a mortgage of £69,818.
Full Bank of England Proposals Below:
At higher levels of indebtedness, borrowers are more likely to encounter payment difficulties in the face of shocks to income and interest rates.
2.2 Rental income is an important factor when determining the ability of buy -to-let landlords to service their debt. Accordingly, a widespread market practice in the buy-to-let lending market is to use the mortgage’s interest coverage ratio (ICR) in assessing affordability. In addition to rental income, some borrowers use personal income to support their ability to service their debt.
2.3 The PRA is therefore proposing that all firms use an affordability test when assessing a buy-to-let mortgage contract in the form of either: an ICR test; and/or an income affordability test, where firms take account of the borrower’s personal income to support the mortgage payment.
2.4 The PRA is seeking to establish a standard set of variables that should be reflected within the ICR test and the income affordability test. To ensure that firms are being prudent in their affordability assessment, the PRA is proposing that firms, among other things, give consideration to: all costs associated with renting out the property where the landlord is responsible for payment; any tax liability associated with the property; and where personal income is being used to support the rent, the borrower’s income tax, national insurance payments, credit commitments, committed expenditure, essential expenditure and living cost.
2.5 As affordability constrains the value of the loan a firm can extend, the PRA is not at this time proposing supervisory guidance with respect to specific loan-to-value (LTV) standards. However, the PRA does expect firms to have appropriate controls in place to monitor, manage and mitigate the risks of higher LTV lending. Interest rate affordability stress test
2.6 The buy-to-let market is characterised by floating, or relatively short-term fixed mortgage rates typically on an interest-only basis. These attributes heighten the sensitivity of buy-to-let lending to changes in interest rates, which increase debt service costs.
2.7 Consequently, the PRA proposes that, when assessing affordability in respect of a potential buy-to-let borrower, firms should take account of likely future interest rate increases. In particular, the PRA proposes that the firm should consider the likely future interest rates over a minimum period of five years from the expected start of the term of the buy-to-let mortgage contract, unless the interest rate is fixed for a period of five years or more from that time, or for the duration of the buy-to-let mortgage contract if less than five years.
In coming to a view of likely future interest rates, the PRA would expect firms to have regard to: market expectations; a minimum increase of 2 percentage points in buy-to-let mortgage interest rates and any prevailing Financial Policy Committee (FPC) recommendation and/or direction on the appropriate interest rate stress tests for buy-to-let lending.
Even if the interest rate determined above indicates that the borrower’s interest rate will be less than 5.5% during the first 5 years of the buy-to-let mortgage contract, the firm should assume a minimum borrower interest rate of 5.5%.
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