Understanding the nuances and complexities of numbers in property investing has always been important, and with rising interest rates, tougher lending rules and proliferating operating costs, the ability to stress test a deal has become essential.
What is Stress Testing?
A buy-to-let stress test is a process most landlords go through when purchasing a property to rent.
It refers to a financial assessment lenders use to evaluate whether one can afford a mortgage on a rental property, even if interest rates rise in the future. Hypothetical interest rates are often applied by the lender to check if the rental income can comfortably cover the loan.
Whilst there are different avenues and criterias for calculating a BTL Stress Test, most logic follows in this manner:
1. Interest Coverage Ratio (ICR)
The rental income required must exceed mortgage payments by a set percentage, and compares the anticipated rental income against the mortgage interest payments – in many cases this would be 125% – 145% depending on the taxpayer rate.
When applying for a BTL mortgage, lenders often focus quite heavily on rental income to determine affordability rather than solely on personal finances.
2. Stress Rate
Rather than using the actual mortgage interest rate, lenders may test affordability at a higher rate (>= 5.5%), even if your rate is lower.
If your mortgage loan is calculated at £275,000 and interest rates are set at 5.5% then here would be a calculation of this all:
Monthly mortgage payment (interest only): £1260.42
Required Rental Income: £1260.42 x 145% (1.45) = £1827.61
Your property’s estimated rental income must be above this threshold, otherwise you cannot pass the stress test.
In having understood how a stress test operates, it’s important to understand stress tests are primarily about risk management:
Lenders are required by the Prudential Regulation Authority (PRA) to apply strict criteria to BTL mortgages to protect both borrower and lender.
– Interest rates can change over time, proliferating your monthly payments. Stress tests ensure that even if rates rise, your rental income is sufficient enough to cover higher payments.
– The status of your tax can impact the stress test outcome, with higher tax liabilities requiring higher rental income to pass the test.
– The stress test will consider the possibility of periods where your property is vacant or your rental income drops. Thus, rental income stability is important.
With the above in mind, your tax status also impacts the outcome of your BTL Stress Test:
– Basic Rate Taxpayers will typically have an ICR of around 125%, making it easier to meet an affordability criteria.
– Higher Rate Taxpayers can increase to 145%, reflecting a larger tax burden on one’s rental income.
– Limited Company BTLs have grown into an alternative for BTL investments for landlords, in which cases the ICR may still be at 125% due to limited companies offsetting the full interest amount.
Stress Tests are a hurdle which you must often pass when securing a mortgage for your rental property. Therefore, it is important you understand how these tests work and the impact your rental income and tax status influence these outcomes.
