The Bank of England has released a consultation paper which seeks views on a supervisory statement which sets out the Prudential Regulation Authority’s (PRA’s) proposals regarding its expectations of minimum standards that firms should meet when underwriting buy-to-let mortgage contracts. The proposals also include clarification regarding application of the small and medium enterprises (SME) supporting factor on buy-to-let mortgages. Of note is a minimum interest rate floor of 5.5% to be used for testing repayment capacity, and tighter rules on affordability testing.
Firms should assess all buy-to-let mortgage contracts from the perspective of whether the borrower will be able to pay the sums due. The underwriting standards set out in this supervisory statement should form minimum standards, regardless of whether the borrower is an individual or a company.
To avoid existing borrowers being adversely affected when re-mortgaging, the expectations do not apply to buy-to-let remortgages where there is no additional borrowing beyond the amount currently outstanding under the existing buy-to-let contract to the firm or to a different firm. In determining the amount currently outstanding, new arrangement fees, professional fees and administration costs should be excluded.
Any reduction in buy-to-let activity and lower buy-to-let mortgage stock will lead to a reduction in short-term revenues for lenders and mortgage brokers. While affected firms may be able to recover some of the reduction in revenues by lending to owner-occupiers or other business activities in the economy, we think some more affected firms may find it difficult to recover lost revenues. Some buy-to-let investors could see an impact on their ability to obtain a buy-to-let mortgage and/or the profitability of their lending activities due to higher deposit requirements. However, affected investors may be able to find returns in other investment opportunities.
Affordability testing
Affordability tools constrain the value of the loan that a firm can extend for a given income and can reduce the probability of default on the loan particularly in an environment of rising interest rates. At higher levels of indebtedness, borrowers are more likely to encounter payment difficulties in the face of shocks to income and interest rates.
Rental income is an important factor when determining the ability of buy-to-let landlords to service their debt. Accordingly, a widespread market practice in the buy-to-let lending market is to use the mortgage’s interest coverage ratio (ICR) in assessing affordability. In addition to rental income, some borrowers use personal income to support their ability to service their debt.
The PRA is therefore proposing that all firms use an affordability test when assessing a buy-to-let mortgage contract in the form of either an ICR test; and/or an income affordability test, where firms take account of the borrower’s personal income to support the mortgage payment.
The PRA is seeking to establish a standard set of variables that should be reflected within the ICR test and the income affordability test. To ensure that firms are being prudent in their affordability assessment, the PRA is proposing that firms, among other things, give consideration to: all costs associated with renting out the property where the landlord is responsible for payment; any tax liability associated with the property; and where personal income is being used to support the rent, the borrower’s income tax, national insurance payments, credit commitments, committed expenditure, essential expenditure and living costs.
As affordability constrains the value of the loan a firm can extend, the PRA is not at this time proposing supervisory guidance with respect to specific loan-to-value (LTV) standards. However, the PRA does expect firms to have appropriate controls in place to monitor, manage and mitigate the risks of higher LTV lending.
Interest rate affordability stress test
The buy-to-let market is characterised by floating, or relatively short-term fixed mortgage rates typically on an interest-only basis. These attributes heighten the sensitivity of buy-to-let lending to changes in interest rates, which increase debt service costs.
Consequently, the PRA proposes that, when assessing affordability in respect of a potential buy-to-let borrower, firms should take account of likely future interest rate increases. In particular, the PRA proposes that the firm should consider the likely future interest rates over a minimum period of five years from the expected start of the term of the buy-to-let mortgage contract, unless the interest rate is fixed for a period of five years or more from that time, or for the duration of the buy-to-let mortgage contract if less than five years. In coming to a view of likely future interest rates, the PRA would expect firms to have regard to: market expectations; a minimum increase of 2 percentage points in buy-to-let mortgage interest rates; and any prevailing Financial Policy Committee (FPC) recommendation and/or direction on the appropriate interest rate stress tests for buy-to-let lending.
Even if the interest rate determined above indicates that the borrower’s interest rate will be less than 5.5% during the first 5 years of the buy-to-let mortgage contract, the firm should assume a minimum borrower interest rate of 5.5%.
Portfolio landlords
The PRA is seeking to establish a standard definition of what constitutes a ‘Portfolio landlord’. Under this proposal, a landlord would be considered to be a Portfolio landlord where they have four or more mortgaged buy-to-let properties across all lenders in aggregate. Data gathered by the PRA shows that there is an increase in observed arrears rates of landlords with buy-to-let portfolios of four or more mortgaged properties.
The PRA is expecting that firms conducting lending to Portfolio landlords do so according to a specialist underwriting process that accounts for the complex nature of the borrower and their portfolio of properties.
Risk management
The PRA is proposing that firms have robust risk management, systems and controls in place specifically tailored to their buy-to-let portfolios. These should include risk appetite statements governing how core risks will be identified, mitigated and managed and monitoring of portfolio concentrations and high risk segments.
The buy-to-let market is dominated by lending originated through intermediaries. There is some concern that firms with weaker underwriting standards may be adversely selected which could result in a concentration of a particular risk on individual firms’ balance sheets. Consequently, the PRA expects firms to have appropriate oversight and monitoring capabilities with respect to their intermediary business.
The SME supporting factor in relation to buy-to-let mortgages
The PRA proposes to enhance the transparency and consistency of the PRA’s regulatory approach by clarifying the PRA’s expectations in relation to application of the SME supporting factor on buy-to-let mortgages.
Under Article 501 of the CRR the SME supporting factor is used to reduce by approximately 24% the capital requirements on loans to SMEs on qualifying retail, corporate and real estate exposures. The PRA does not consider that buy-to-let borrowing falls within the objective of the SME supporting factor described in Article 501 CRR. The PRA proposes to clarify in the supervisory statement that it expects firms to consider the intended purpose of a loan before applying the SME supporting factor. The SME supporting factor should not be applied where the purpose of the borrowing is to support buy-to-let business. The PRA would expect firms to comply with the spirit and intent of this statement.
