Bank of England governor Mark Carney wants buy to let mortgage rent cover ratios to ensure landlords are safeguarded from financial risk when interest rates rise.
In his latest Financial Stability Report, Carney outlines his worries about landlord borrowing and explains that if lenders raised rates by 3%, around six out of 10 landlords would see their rents fall below the 125% rent cover stress test.
In the report – issued every six months – Carney argued buy to let is driving the mortgage market, but because fewer restrictions apply to borrowing landlords are more prone to fall into financial problems which could trigger a plunge in home prices.
What is rent cover?
Rent cover is a formula buy to let lenders stress test whether a letting property is affordable for the borrower.
Most lenders calculate rent cover by comparing the annual interest charged at 5% against 125% of the annual rent generated by the property.
For example, a landlord wants a 75% mortgage against a home valued at £200,000. The mortgage is £150,000. The stress test interest rate is £150,000 x 5%, which is £7,500 or £625 a month.
To pass the rent cover test, a tenant must pay at least £781 a month rent (£625 x 125%).
What powers does the Bank of England want?
The Bank wants to pull the strings on buy to let lending with powers to:
- Limit the loan to value of a mortgage – loan to value is the percentage amount a lender is prepared to let a landlord borrow against the value of a property – 75% in the above example
- Order lenders to adjust the rent cover ratio
- Set debt to income ratios to stop landlords from borrowing more than they can afford to repay
Why is buy to let lending a problem?
Carney is concerned some smaller buy to let lenders are stretching the finances of landlords by raising loan to values. If the mortgage rate rises, these landlords may find their repayments are more than their rents, which will mean the homes are sold or repossessed and sold by lenders.
Either way, this could force house prices down and undermine the buy to let market.
Barclays Bank has already upped their rent cover test to 135% as a result of the Bank report.
Will April’s mortgage interest relief changes impact mortgages?
The change affects landlords paying income tax at 40% and 45% by phasing out tax relief on mortgage interest payments at the higher rates down to 20% by 2020.
The rent cover test does not include the rate a landlord pays income tax. However, rental profits are likely to fall as mortgage interest relief is cut, affecting the ability of landlords to pay their loans.