What is an ICR?
The amount that income ‘covers’ mortgage payments, expressed as a % and based on:
Income / Mortgage Payment = ICR %
Why ICR is important
This is essential for determining whether a landlord will be able to make the mortgage payments and typically uses only the rental income from the property.
Higher ICR means lower risk and vice-verse. Lending is all about risk assessment and pricing for risks so ICR is a crucial assessment tool. ICR applies in all sorts of lending scenarios, especially commercial mortgages. This focuses on BTL.
What should BTL ICR look like and why?
Rent should be greater than mortgage payments due to a number of reasons, including:
- Tax is due on rental income in most cases
- Voids (period where property is empty)
- Tenants not paying or making late payments
- A property left in bad condition, leading to costs to refurb and also a void
- Interest rate changes (could go up)
- Changes in rental income (could go down)
The level with which rental income should be above mortgage costs should vary depending on the risk of all of the above factors as well as the risk related to the property or the landlord.
Required ICRs may thus vary by the following:
- Lender
- Product type
- Property
- Tax band / legal entity purchasing/remortgaging
- Tenant type or tenancy type
ICR Background
The PRA (Prudential Regulation Authority) have implemented minimum requirements on ICR % levels with a view to bringing stability to the BTL market and the housing market.
As a result of these minimum standards, many lenders have adopted similar interpretations of ICR requirements BUT note that there are important differences and these need to be understood to help those on the fringes of ICR mortgage affordability.
The PRA have also implemented tests to ensure landlords with 4 or more properties are being assessed on their portfolio as a whole from an ICR, LTV and risk perspective.
Understanding the ICR Calculation
Rent
Rent is the gross rent from the property over the agreed period of assessment (i.e. 1 year or 1 month). Typically this is annual rent as this is easy to calculate and also interest is typically quoted as an annual price. Some lenders only take a % of expected rent if it is not already being received.
Interest
Interest is subject to a minimum as stipulated by the PRA and as such is not always the interest the borrower will initially pay (the pay rate). As the interest rate used may be different from that of the mortgage product itself, it is given a different name, it is called a Stress Rate or Stressed Rate.
The principle being that the interest used to calculate ICR should be calculated in a manner that enables it to still perform when under pressure from any of the variables previously mentioned that affect the ICR (voids, rental income, interest rate changes etc).
Stress Rates
Stress Rates are dependent on the pay rate of the product over the initial rate period (or whole term if no initial rate deal) and also, if the initial rate is fixed for a period of 5 years or more.
If
Initial Rate < 5yrs = Pay Rate
OR
Initial Rate Fixed AND for 5 Years (or more) = Higher of… 5.5% or Pay Rate + 2%
Most lenders have a similar interpretation of the above but some fall outside the PRA so can have a more flexible approach. It pays to understand the lender’s approach for all scenarios.
Typical BTL ICR Rates
Low risk property, low risk landlords, low tax band landlords, limited company, LLPs = 125%
Medium risk property, medium risk landlords, higher tax bands = 140%-145%
Higher risk property, higher risk landlords = 150% – 160%
Note that this is a great oversimplification, lenders have their own assessments on the above but this demonstrates the principles involved.
Lender Examples
Take the time to consider the various ICR stress rates available on the lender product sets and how they may vary based on product selection, LTV etc.
Take the time to consider how lenders set their ICR threshold % and how it varies based on the landlord’s position and the perceived risk of the property being purchased.
Using a minimum of 6 lenders, explain the different stress rates available in their product sets and explain various different assessments of the ICR threshold.
Consider the practical implications of the above for landlords, brokers and us.
- ICR ADVANCED DETAIL
ICR Mixes or Bespoke ICR Rates
In certain scenarios, with more than one borrower, perhaps there are people in different tax bands purchasing a property (or remortgaging).
Individual A may appear in the lower risk ICR threshold for a lender, e.g. 125%, whereas the other applicant may fit in a different and higher ICR threshold.
Some lenders will mix the required ICR to allow for a mixed ICR, after all, neither 125% or a 140%+ ICR would seem appropriate in that scenario. These arrangements can really help customers on the margin of ICR affordability so it is important to understand all options.
Income Top-Up
The above all discusses how we can change the product type to minimise the stress rate and maximise ICR if this is needed. We can also address the income element in the equation by allowing the borrowers to use any ‘surplus’ income (or disposable income) to “Top-Up” the rental income.
If a lender allows this, it may let the borrower take out the BTL mortgage as their income can support and voids or issues with rental income or interest rate changes. This is known as Income Supported BTL, Income Top-Up or Income Top-Slicing and is available from a small number of lenders.
All of the ICR ratios still apply PLUS an additional ICR test. That is the Income Top-Up Threshold ICR %. This is set by the lenders and as it is a threshold before any top-up can be applied it is lower than the ICR threshold. Typically this is 110% or more.
Why is there an Income Top-Up Threshold?
Risk assessment (again!). Applying this threshold means that most mortgage payments are covered using rental income, only when the rental income has issues , voids or repairs will the borrower need to use their own income to support the mortgage payment.
This is a lower risk than supporting a residential mortgage and a BTL mortgage wholly from your own income. A questionable investment!
Income Top-Up Example
Customer has disposable income of £12,000. They miss ICR of 125% by 5%, they can use their disposable income to take them over the 125% if the £12,000 is sufficient to do so (add it to the annual rental income in the calculation). This is not possible if the ICR was under 110% in the first place.
ICR Calculation Becomes…
(Annual Rent + Income Top-Up) / (Mortgage Amount x Applicable Stress Rate) = ICR%
Portfolio Stress Tests
These tests only apply to Portfolio Landlords as defined by the PRA. See training on Landlord Types.
Portfolios must be assessed to determine their risk weighting in the following areas:
LTV – If this is too high, remortgages will not be possible and the risk is that landlords will be stuck on higher SVR rates (refer to training) and the ICRs will fall. This makes lending to the landlord riskier.
ICR – If this is too low, there is a strong chance that remortgages will not be possible and that landlords will be stuck on higher SVR rates (refer to training) and this will cause ICRs to drop further. Any rental income generated from other property may thus need to be spread across a wider portfolio. The risk of lending in these situations is higher.
Individual Tests – Each property is assessed on its own merits, ensuring that each property meets minimum requirements of LTV and ICR.
Aggregate Tests – As a whole, the portfolio is assessed on LTV and ICR and will need to meet a minimum threshold in aggregate, i.e. as a whole.
‘Under Water’ – A phrase meaning the existing property portfolio, or a property, is below 100% ICR. If you own an asset that costs you more than it generates, it is not an asset but a liability.