Buy-to-let mortgages: how do lenders account for tax when assessing affordability?

The purpose of Bank Overground is to share our internal analysis. Each bite-sized post summarises a piece of analysis that supported a policy or operational decision.
Published on 27 November 2020
Recent rental income tax changes have made buy-to-let investments more expensive for higher-rate taxpayers. They now need more rental income to breakeven, but lenders are not fully accounting for this when assessing affordability.

In 2016, the Prudential Regulation Authority (PRA) published its expectations of lenders’ underwriting standards for buy-to-let mortgages. In particular, the PRA expects lenders to take account of likely future interest rate increases when assessing affordability for a potential borrower.

Affordability for buy-to-let mortgages is typically assessed by looking at the interest coverage ratio (ICR). This is the ratio of gross rental income to mortgage interest repayments.

Lenders typically look for a minimum ICR of 125% calculated using an appropriate stressed interest rate (stressed ICR). A stressed ICR of 125% reflects the amount of gross rental income required for landlords to breakeven, factoring in the costs of mortgage repayments (including a potential increase in interest rates), tax and property maintenance.

Before 2017, landlords paid tax at their income tax rate on rental income, net of mortgage interest repayments. Changes to Mortgage Interest Tax Relief (MITR), phased in between 2017 and 2020, require landlords to pay tax on their rental income without offsetting mortgage interest repayments. Instead, they are entitled to a tax credit equal to 20% of their mortgage interest repayments.

The MITR change does not affect basic rate taxpayers, but increases the tax bill for higher-rate taxpayers. For a given level of mortgage repayments, higher-rate taxpayers now need more rental income to breakeven.

The PRA expects lenders to take income tax into account when assessing affordability. If the MITR changes were strictly enforced for affordability testing, higher-rate taxpayers would need to meet a higher stressed ICR of 167% to be assessed to the same standard as an ICR of 125% for basic-rate taxpayers.

Most lenders assess higher-rate taxpayers against a minimum stressed ICR of around 145% (Chart A). So compared to basic-rate taxpayers, lenders are accepting a lower net rental income for given mortgage repayments for higher-rate taxpayers. All else equal, this could make lending riskier.

However, the risk posed by such lending is low at present. The overall quality of buy-to-let lending has improved since 2016. And tax changes introduced since 2016, including the MITR, have meant the buy-to-let market has been very subdued.

Lenders may also take into account that higher-rate taxpayers have higher incomes and tend to have more diversified income sources to finance their mortgage repayments. More detailed analysis would be needed to fully understand the balance of these risk factors.

We will continue to monitor this risk in buy-to-let lending.

Chart A: Higher-rate taxpayers now need more rental income to breakeven, but lenders are not fully accounting for this

Stressed ICR distribution on new buy-to-let lending since 2019, by income tax band (a) (b)

Stressed ICR distribution on new buy-to-let lending since 2019, by income tax band.

Footnotes

  • Sources: Lenders’ submissions to the Bank of England’s buy-to-let data collection and Bank calculations.
  • (a) Only includes lending to which the affordability test requirement applies. This means we exclude lending by non-banks, lending to corporates, consent-to-let loans, lending regulated by the Financial Conduct Authority, loans with a fixed-rate period of five years or more, and remortgaging with no additional borrowing. We also exclude loans where personal income is used to supplement rental income for affordability testing.
  • (b) The sample consists of nine lenders, which account for nearly half of the market of new buy-to-let lending described in (a); not every reporting lender submits breakdown by borrowers’ tax bands.

This post was prepared with the help of David Seaward and Alex Ying.

This analysis was presented to the Supervision, Risk and Policy Committee in September 2020.

Share your thoughts with us at BankOverground@bankofengland.co.uk

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