In simple terms, a stress test is the calculation lenders use to determine how much they will lend to the borrower. Here is an explanation of how it is calculated, why the the calculation is getting tougher and what the change ultimately means for borrowers.
Lenders take the mortgage interest payment based on a certain interest rate, then require that the rent covers this payment with something to spare. The exact calculation varies from lender to lender, and even from deal to deal.
As an example, the lender may say that the rent needs to cover the mortgage interest payment assuming an interest rate of 5.5% (even if this is not the actual rate the borrower will be paying) with 125% coverage (officially called the Interest Cover Ratio or ICR).
Putting this into a real life example, if a borrower is taking a mortgage of £100,000 then the monthly interest payment based on a rate of 5.5% will be £458 per month. However, as they need the rent to be 125% of this figure, the rental income would actually need to be £573 per month for the numbers to work.
For quite a few years now, the average stress test used by buy to let lenders has been 125% at 5-5.5% but this is changing.
Why do lenders use this stress test?
There are two key stresses here – the rate and the margin.
1. The rate: Lenders calculate the monthly cost on what we call a notional rate (so in the above example, 5.5%) even if this is not the rate the mortgage will be on. The reason for this is to make a proviso for if interest rates go up.
2. The margin: The margin (125% in the above example) is to ensure that the borrower has surplus cash flow from the property which would be used to cover additional costs – services charges, repair costs, building a slush fund for rental voids and so on.
What is changing?
We are currently going through a period of change with regards to the calculations lenders use. We saw these start to go up last year – this was based on a very real concern from the banks that their calculations were not factoring in a sufficient cushion for interest rate rises.
Additionally, some lenders had reversion rates (the rate the mortgage defaults to after the initial period is up) of up to 6.74% which the borrower may end up paying if they didn’t renegotiate their deal.
This meant that some borrowers could have ended up in a negative cash flow position.
In addition to this lenders are now looking forward to the tax changes which are being phased in over the next few years, which reduce the amount of mortgage interest some landlords can offset against their rental profit. For many personal borrowers (in particular higher and high rate tax payers), the calculations used historically would have meant a negative cash flow position so lenders are looking to increase their stress tests to make provision for this.
This year we have already seen The Mortgage Works, Keystone Property Finance, Foundation Home Loans, Barclays and Newcastle Building Society upped their stress test calculations for individual borrowers to 145% at 5.5%.
It is worth noting that both Keystone and Foundation will consider allowing individual borrowers to use 125% at 5.5% (which applies to limited company borrowers), if they can demonstrate that they are, and are likely to remain, basic rate tax payers.
How will this affect borrowers?
In short what this means is that you get less bang for your buck. Whereas you used to be able to borrow £19,200 (on average) for every £100 of monthly rent, the average calculation now means this has reduced to £16,500.
This means that some borrowers will be unable to remortgage, or at least be restricted in terms of the deals available to them, and new purchasers may well need to put in a bigger deposit than before.
For remortgage clients simply looking to get a new rate, your existing lender is very likely to be able to offer you a new deal without revisiting the numbers so it is always worth talking to them about what they can offer you.
If you have used an intermediary only lender, we can negotiate with the lender on your behalf.
Some lenders are still working on lower calculations (for how long remains to be seen) so it is worth speaking to a broker who has an overview of the market to see whether the numbers can work from across the market.
We are also seeing an increase of lenders using ‘top slicing’ which although complicated, involves a bit of lateral thinking from the lenders so well done to those guys!
For borrowers financing their buy to lets through limited companies, the very good news is that as the new tax rules won’t apply to you, lenders are not necessarily bringing the increased stress test across to their corporate rates.
So it really is worth considering operating your portfolio via a limited company but of course, do take professional advice in this regard either from a qualified accountant or a tax specialist.
For more information please call my direct line on 01732 471647 or visit my profile.
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