Calculating the affordability of a buy-to-let mortgage is important in two ways: mortgage lenders will use an affordability assessment in calculating how much they will let you borrow, and – perhaps more importantly – it is a vital measure of how profitable the buy-to-let property will be. If you get your sums wrong, it could be the difference between making a profit and making a loss.
Whenever anyone applies for a mortgage, the lender will carry out an affordability assessment. For a standard residential mortgage, this involves assessing the applicant’s verifiable income as well as any monthly outgoings, such as existing credit commitments. These factors, in combination with external credit reference checks and internal credit-scoring processes, determine whether the lender will approve the mortgage application, and how much the applicant can borrow.
When it comes to buy-to-let mortgages, however, a different approach is invariably used. Instead of basing the affordability calculations on salary and existing commitments, the lender will usually compare the projected rental income generated by the property, with the mortgage interest payments. What this means in practical terms is that they will be looking for your rental income to be more than the mortgage interest by a certain margin.
Until recently, most mortgage lenders would typically look for rental income to be 125% of the mortgage interest payment as calculated at a predetermined interest rate of 4.99%. However, at the beginning of 2017 the financial regulator, the Prudential Regulation Authority (PRA), set down tougher rules on buy-to-let affordability assessments. Now it is more common for buy-to-let lenders to look for rental income to be 140% or 145% of the mortgage interest payment and now at a predetermined rate of between 5% – 5.5%. Certain types of buy to let, such as borrowing to purchase a House in Multiple Occupation (HMO) can see even higher affordability margins used – up to 170%.
As already touched on, the guidelines from the PRA mean that buy-to-let affordability assessments are not quite as straightforward as comparing the projected rental income with the actual projected mortgage interest payments. Instead, they require buy-to-let lenders to “stress test” affordability. That means that in most situations rather than using the actual interest rate of the mortgage that you are applying for to assess affordability, the lender will use a predetermined interest rate that assumes a future interest rate rise. The purpose of this is to ensure that your ability to repay the mortgage based on the rental income will remain even if the economy changes and interest rates start to increase.
The stress-testing rules mean that, unless the mortgage product’s interest rate is fixed for five years or more, lenders should base their buy-to-let affordability calculations on the higher of:
- A hike of at least 2% above current rates
- Market projections of future interest rates
- A minimum stress-test rate of 5% – 5.5%