Dealing with interest coverage ratio dilemmas – Landbay
Since the announcement of the so-called mini-budget on September 23, 2022, which caused widespread chaos, mortgage rates have skyrocketed and, in many cases, products have disappeared.
Bank of England base rates and swap rates have risen, posing a dilemma for lenders trying to price mortgage products. We cannot provide mortgages at a loss, so we have no choice but to raise rates.
But another dilemma facing lenders is the interest coverage ratio (ICR), a regulatory requirement established by the Prudential Regulatory Authority (PRA).
Although many non-bank rental lenders, like us, are not regulated by the PRA, we nevertheless follow all established regulations. This is important to our integrity and means that we can work with funders who are regulated by the PRA.
Lenders vary their typical ICR margins between 125% and 145% depending on the client’s tax situation. This is then constrained to the prevailing mortgage interest rate plus a fixed margin or nominal interest rate.
ICR ’causes a headache’
It is the ICR that causes such a headache in the market because it is what dictates a homeowner’s borrowing potential.
With rising interest rates, this means that to meet the ICR, rental requirements will also be higher. What happens now is that the ICR calculations dictate that borrowing is limited, in many cases less than the borrower’s existing debt.
As lenders, we need to ensure that the ICR calculations are suitable for both us and the borrower.
One way to do this is to charge a higher upfront fee in order to have a lower interest rate, because the lower the mortgage interest rate, the lower the rental stress rate.
Essentially, the total overall cost will be similar during the initial offer period if the fee is higher, and the rate is lower than the normal pricing models we’ve seen previously (although adding the completion erodes their capital if not managed properly and costs a bit more over the initial period of the offer in interest on the fees themselves).
Here are some examples to illustrate what I mean.
Calculation of the ICR
As of March 2022, a £150,000 five-year fixed rate mortgage at 2.99% – ICR at 125% requires a minimum rental income of £467.
In October 2022, with a rate of 6.59%, the minimum rental income is £1,029.
Impact on ICR of different fees and interest rates
Keeping a fixed rate mortgage of £150,000 over five years, the change in fees and interest rate would require the following minimum rental income to meet the ICR:
Two per cent fee – 6.49 per cent rate = required rent £1,014
Three per cent fee – 6.69 per cent = required rent £1,045
Two per cent fee – 6.89 per cent = required rent £1,076