Buy-to-let mortgages are mostly exempt from FCA oversight, meaning that BTL applicants avoid the stringent affordability checks that residential applicants face (especially nowadays). However, mortgage lenders still need to know that the property is a good proposition; in other words, that it will be self-financing.
This means that BTL lenders usually use rental income, rather than personal income, to calculate affordability. As mortgage interest payments tend to be the largest monthly outgoing for a landlord, the rent needs to meet this expense as a minimum. But due to other factors – running costs, voids, arrears and the possibility of increasing payments, to name a few – lenders typically require a working margin too.
The ratio of operating income over debt is often referred to as ‘debt-service coverage ratio’ (DSCR), and is relatively easy to calculate; simply divide your rental income by your monthly interest repayments and express it as a percentage. Say, for example, that you rented out a property for £1,100 a month, and your monthly mortgage repayments were £880 per month.
– 1,100 / 880 = 1.25
– 1.25 = 125%
125% is a typical figure for the ‘rental cover’ many lenders require. It’s a back-of-a-matchbook assurance that you will maintain a positive cashflow and continue to meet your mortgage repayments.
There is one important fact to bear in mind about rental cover calculations, however: lenders very rarely use the headline interest rate to work out the repayments you need to meet. More often than not, the rate is entirely nominal, and tends to hover around the 5–6% mark.
The upshot of this is that what you think is an affordable proposition may not be suitable as far as your lender is concerned. This continues to be a sticking point for a number of our applicants, who weren’t aware that lenders stress-tested applications in this way. So allow me to go into a little more detail about how the calculation works.
Calculating rental cover
Let us say that you need to borrow £100,000 to fund a property purchase. The lender requires rental cover of 125%, which they calculate using a nominal ‘reference rate’ of 5.49%.
First, they will work out your hypothetical repayments:
– 100,000 x 0.0549 = 5,490
– 5,490 / 12 = £457.50
This figure could well be much higher than what you would actually be repaying.
Then, the lender will calculate the rental cover you need to achieve:
– 457.5 x 1.25 = £571.86
Often, lenders will use the higher of the nominal rate or the pay rate (the rate you will initially be charged). Some may even use the reversionary interest rate, which is typically their standard variable rate. And because of the higher rates used, a lender may ask for a higher rent than is actually achievable, leading to the application being declined.
Forewarned is forearmed
The lender will usually instruct a valuation of a property to determine what rent can be achieved, by which point a number of non-refundable fees may already have been paid.
To avoid disappointment, you can use the calculations above to predict whether the property you wish to buy will achieve a satisfactory rent. You only need to know the amount you wish to borrow, and the local market rent for a comparable property (you may even have already instructed a valuation yourself).
First, multiply the loan amount by a hypothetical interest rate a lender is likely to use (the higher the safer) and divide the result by twelve to get your monthly repayments. Then multiply this amount by between 1.25 and 1.35 to find out if it exceeds your potential monthly rental income.
In a number of cases, particularly London and the South East, the rental income won’t meet the amount required by a high-street lender. This is because property prices in these areas are rising faster than rents, making the rental yields lower.
There are specialist lenders who can cater for this situation. Some will calculate rental cover against a lower interest rate, such as the pay rate of the product advertised. Others will use a smaller rental coverage ratio, such as 110% or even 100% – though they typically impose a maximum LTV and minimum property value, as well as geographical restrictions, for such applications.
For a full picture of your options, speak to a professional buy-to-let mortgage advisor.
Written by Ben Gosling for Commercial Trust. Commercial Trust is a specialist commercial broker that offers expert product and investment advice for buy-to-let, bridging and commercial mortgage customers. For more information, visit www.commercialtrust.co.uk.
The FCA does not regulate some forms of buy to let mortgage.