Buy-to-let underwriting is changing right now

Expert view: Andrew Turner, CEO, Commercial Trust

Andrew TurnerIn this article I look at changes to buy-to-let mortgage underwriting being brought about by The Prudential Regulation Authority (PRA) in September 2016, and the subsequent and ongoing impact upon maximum borrowing thresholds.

Why have these changes come about?

During 2015 and 2016 the Prudential Regulation Authority (PRA) undertook a review of the underwriting standards of 31 buy-to-let lenders, which at the time constituted approximately 92% of the market.

It identified concerns that lender plans for growth may result in a relaxation of underwriting standards and thereby make come borrowers vulnerable to changes in the economy.

Having gone through a process of consultation, (from which Consultation Paper CP11/16 “Underwriting standards for buy-to-let mortgage contracts” was published in March 2016) a Policy Statement (Policy Statement PS28/16 published in September 2016) was issued which fed back on responses received for the changes the PRA and finalised the details of the changes. It is supported by their Supervisory Statement SS13/16.

What is the aim of the policy?

The PRA changes aim to ensure that the firms they regulate take a “prudent” line in lending, “prevent a marked loosening in buy-to-let underwriting standards”, and “curtail inappropriate lending and the potential for excessive credit losses”.

To achieve this, they have imposed tighter checks on assessing the affordability of buy-to-let connected to mortgage applications. By doing so, the aim is to create a buffer for the investor if interest rates were to rise, or during void periods, so that repayments would not become unaffordable.

Timeframe for the changes

The changes required by the PRA are being phased in by way of a two-step implementation.

By 1st January 2017 all lenders affected by the policy had to implement the required changes to interest cover ratio tests (to include the impact of personal tax changes) and interest rate affordability stress tests.

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By 30th September 2017 all remaining changes must be in place.

Amidst its feedback to respondents, the PRA demurred on any need to hold back the second phase until the impact of the EU referendum result and changes to tax law were apparent, citing that in its view “the expectations for minimum underwriting standards included in the final SS [Supervisory Statement] broadly reflect existing practice for most lenders in the market today (with the possible exception of firms’ incorporation of the recent personal tax changes)."

Which property investment deals are exempt from the changes?

  • Holiday lets
  • Bridging loans
  • Property investment lending
  • Corporate lending

However, these deals will be monitored by the PRA for a prudent approach to underwriting.

Also exempt are:

  • Consent-to-let deals (where an owner-occupier applies to let out a property financed by a residential mortgage on a temporary basis) although these are to be considered when assessing affordability of a new buy-to-let mortgage
  • Buy-to-let deals with a term of 12 months or less
  • Buy-to-let remortgages where the existing borrower does not wish to make any additional borrowing beyond the amount outstanding on the current loan (fees and administrations costs for arranging the new mortgage product are excluded when determining this).

This last point offers a solution to those of you whose buy-to-let mortgages, at renewal, fall outside of the new rules which would otherwise have rendered you only able to revert to the standard variable rate of your existing lender.

Five year fixed rate products

Where lenders are offering a five year or more fixed rate product, they will not be required to increase the affordability stress test interest rate to 5.5% per annum.

Are all buy-to-let mortgages subject to the changes?

No…

The Policy stipulates that it “is relevant for all PRA-regulated firms that undertake buy-to-let lending that are not already subject to Financial Conduct Authority (FCA) regulation.”

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Will there always be some buy-to-let mortgages which won’t be affected?

A good question, and one which was understandably asked of the PRA, amongst responses to the initial consultation paper. It’s comments on this point simply indicated that the FCA “continues to monitor this section of the market closely”.

The Bank of England announced on the 16th November 2016 that the Financial Policy Committee have been given powers over both FCA and PRA regulated buy-to-let lenders:

"From early 2017, the FPC will be able to direct the Prudential Regulation Authority (PRA) and Financial Conduct Authority (FCA) to require regulated lenders to place limits on buy-to-let mortgage lending in relation to:

- loan-to-value (LTV) ratios
- interest coverage ratios (ICRs)"

Source: For more information on the announcement visit the news story on the Government's website.

If you feel these changes may impact your portfolio plans, contact our advisors for a personalised illustration of your buy-to-let options:

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What are the rules that determine PRA regulation?

The PRA regulates banks and insurance companies, for more detail on PRA regulated activities, see Article 2 of The Financial Services and Markets Act 2000 (PRA-regulated Activities) Order 2013.

Where a lender does not take deposits (e.g. they may be funded by shareholder equity and/or bank loans) that lender is likely to be regulated by the FCA. For more detail on FCA regulated activities, see section “Regulated activities” on the FCA website.

How complex are the changes?

Rental calculations are exceptionally complex. No two lenders approach rental calculations the same way. On top of this, additional layers of complexity may be thrown into the mix with a given application, depending on the lenders assessment of the deal.

How did lenders implement the changes?

The PRA are not being prescriptive in the way lenders have to implement affordability testing, but they must assess:

“2.1 (a) whether the income derived from the property is sufficient to support the monthly interest cost of the mortgage payments using an interest coverage ratio (ICR) test; and/or
2.1 (b) if firms are taking account of personal income as a means for the borrower to support the interest and capital (if applicable) monthly mortgage payments, whether that income, in addition to any income derived from the property, is sufficient to support the mortgage payments using an income affordability test.”

Source: Supervisory Statement SS13/16

The assessment of affordability that a lender makes must not be based on the equity in the property being used as security, nor must it take account of future increases in property prices.

Do you have 4 or more mortgaged buy-to-let properties?

The research undertaken by the PRA highlighted that arrears rates increased as portfolio sizes increased. In keeping with the overarching aim of reducing arrears, it has asked lenders to take a specialist approach when underwriting deals for portfolio landlords.

If you own four or more mortgaged buy-to-lets, then this will apply to you; the PRA defines you as a portfolio landlord.

To demonstrate adherence to a specialist underwriting process it is likely you will be asked for more information about yourself by a lender than you have experienced in the past.

The information could relate to:

  • Your experience of the buy-to-let market and your understanding of all of buy-to-let finance
  • Your assets and liabilities (including tax)
  • The merits of lending on new properties based on your portfolio and business plan
  • The historical and future expected cash flows related to your portfolio

What does it all mean, in real terms?

Your upper borrowing limits are now a lot lower than they were in the past, especially for landlords looking to raise capital.

Due to the variety of ways lenders impose rental calculations, there are no sweeping generalisations or rules that I can give on the impact of the PRA changes. However, below are some hypothetical examples that aim to illustrate my point.

Historically, if you were looking to buy a rental property valued at £190,000, with rental income of £750 a month, a lender may calculate your maximum borrowing based on covering 125% of monthly mortgage repayment with the rent you would be charging and a flexed mortgage rate of, say, 5%. This would result in your maximum borrowing being £144,000:

(Rent x 12 months / rental coverage)/flexed mortgage rate

i.e. (£750 x 12 / 125%) / 5% = £144,000 maximum borrowing

If you then apply the type of changes to the rental coverage and the flexed rate, that the PRA are imposing on their lenders, this could become more like:

(£750 x 12 / 145%) / 5.5% = £112,852 maximum borrowing (over £30,000 less)

Below are further examples, applied to hypothetical figures, to illustrate the nature of the potential impact upon borrowing brought about by the PRA changes.

Property value £100,000
Loan amount £75,000
Monthly rental income £500
Loan to value 75%
Max. loan at 125% x 5% £96,000
Max loan at 145% x 5.5% £75,235
Difference in max. borrowing -£20,765
Property value £175,000
Loan amount £131,250
Monthly rental income £700
Loan to value 75%
Max. loan at 125% x 5% £134,400
Max loan at 145% x 5.5% £105,329
Difference in max. borrowing -£29,071
Property value £300,000
Loan amount £225,000
Monthly rental income £1,200
Loan to value 75%
Max. loan at 125% x 5% £230,400
Max loan at 145% x 5.5% £180,564
Difference in max. borrowing -£49,836

A closer look at the changes facing landlords

Below are three hypothetical scenarios based on common landlord objectives for their buy-to-let mortgage needs. In each example, I have compared the scenario based on the more flexible borrowing previously on offer with a borrowing scenario using the sort of calculation the PRA requires its lenders to use now.

The scenarios and figures below are for illustrative purposes only and should not be interpreted as fact.

Scenario 1: A landlord has a portfolio of properties from which they wish to raise £100,000 for the purchase of another property.

Objective Raise capital from portfolio to purchase an additional property
Combined value of existing portfolio: £750,000
Total existing borrowing: £450,000 at 60% loan to value
Total existing rental income: £3,200
Capital required for new purchase £100,000
Maximum borrowing
125% rental coverage and 5% rate: £614,400 - £450,000 = £164,400
Can the deal go ahead? YES - The total amount the investor can raise exceeds the £100,000 required
145% rental coverage and 5.5% rate: £481,504 - £450,000 = £31,504
Can the deal go ahead? NO – The total amount the investor can raise is £68,496 short of the target capital raising of £100,000

Scenario 2: An existing landlord wants to buy another property, they have a £55,000 deposit and the property they are looking at is valued at £150,000 and will attract £500 rent.

Objective Buy new rental property
Value of property being purchased: £150,000
Deposit: £55,000
Rental income: £500
Maximum borrowing
125% rental coverage and 5% rate: £96,000 loan
Can the deal go ahead? YES - The total amount the investor can raise exceeds the £150,000 required
145% rental coverage and 5.5% rate: £75,235 loan
Can the deal go ahead? NO – The total amount the investor can raise is £22,765 short of the property value of £150,000

Scenario 3: A individual is looking to invest in bricks and mortar as a new venture and has £75,000 in savings to invest in buy-to-let. They wish to buy two rental properties which will attract £800 and £650 respectively.

Property valueLoan amount
Objective First time landlord looking to buy two rental properties
Total value of property being purchased £350,000
Deposit: £75,000
Rental income: £1,450
Maximum borrowing
125% rental coverage and 5% rate: £278,400 loan
Can the deal go ahead? YES - The total amount the investor can raise exceeds the £350,000 required
145% rental coverage and 5.5% rate: £218,181 loan
Can the deal go ahead? NO – The total amount the investor can raise is £56,819 short of the property value of £150,000

What should I do?

If you are planning new or further investment in buy-to-let, be aware that your borrowing options may be different from expectations. To discuss your current options, contact the advisors here, they will be happy to help.

Discuss your options with our experts

This information should not be interpreted as financial advice. Mortgage and loan rates are subject to change.

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