For anyone planning to enter the buy-to-let market, understanding lender affordability rules is essential. One of the most important measures lenders use is the interest coverage ratio, commonly referred to as “ICR”. This calculation plays a key role in whether a landlord qualifies for a mortgage and how much they can borrow.
Aspiring landlords often focus on deposit size, property value and headline mortgage rates. However, even with a large deposit, a mortgage application can fail if rental income does not meet the lender’s ICR requirements. This article explains what ICR is, how it is calculated and why it matters.
What does ICR mean?
ICR stands for interest coverage ratio. It is a metric lenders use to assess whether the rental income from a property is sufficient to cover the mortgage interest payments. The ratio measures how comfortably the rent received can service interest costs. Lenders use this to protect themselves against default, particularly if interest rates were to rise in future. If the rental income does not meet the lender’s minimum threshold, the lender may reduce the loan amount or decline the application altogether. For landlords, the interest coverage ratio is, therefore, one of the most important numbers to understand before applying for a buy-to-let mortgage.
How the interest coverage ratio is calculated
The calculation itself is straightforward in principle, although lenders apply their own assumptions. The basic formula is annual rental income divided by annual mortgage interest payments. The result is expressed as a percentage. For example, if annual rent is £15,000 and the annual interest cost is £10,000, the interest coverage ratio or ICR is 150%. However, lenders rarely calculate interest using the actual mortgage rate. Instead, they apply a higher stressed rate to simulate potential future rate increases. This makes the interest coverage ratio more conservative and helps lenders manage longer-term risk.
Why lenders use stressed interest rates
Lenders apply stressed interest rates because mortgage rates can change significantly over time. Even if a landlord fixes their rate for a few years, future refixing or refinancing may occur at a higher rate. By calculating interest at a stressed rate, lenders try and ensure that rental income would still cover interest payments under less favourable interest rate conditions. This approach reduces the risk of defaults during periods of rising rates.
For landlords, this approach means that affordability is judged against a tougher benchmark than current market rates.
Typical ICR thresholds used by lenders
Most buy-to-let lenders set a minimum ICR requirement. This threshold varies depending on the lender, borrower profile and their tax position.
Common thresholds include:
- 125%, often used for limited companies and basic rate taxpayers
- 145%, commonly applied to higher-rate taxpayers
How tax position affects ICR
A landlord’s tax position plays a role in ICR calculations. Higher-rate taxpayers are often subject to stricter thresholds because tax reduces net rental income. Lenders take this into account by requiring a higher ICR to compensate for the impact of taxation. Limited companies are usually assessed differently, as corporation tax operates separately from personal income tax. This distinction is also one reason many landlords consider company structures for buy to let investments. It can make meeting the interest coverage ratio easier, depending on individual circumstances.
Why ICR matters for aspiring landlords
For first-time landlords, ICR can become a barrier to entry. Even with a healthy deposit, a property may not generate enough rent to satisfy lender affordability rules. This has several implications:
1. It determines borrowing power
The interest coverage ratio is a key factor in calculating maximum loan size. If the expected rent is low relative to stressed interest costs, borrowing capacity will be restricted. This can be surprising for new investors who assume that deposit size and adequate rent at current interest rates are the primary determinants of affordability.
2. It influences property choice
Properties with strong rental demand and higher yields are more likely to meet ICR requirements. In lower-yield areas, even modest borrowing might not meet lender criteria.
3. It affects long-term resilience
A higher ICR indicates that rental income comfortably exceeds interest costs. This can also provide a cushion against void periods and an increase in maintenance costs, as well as future interest rate rises. From a financial planning perspective, the interest coverage ratio acts as an indicator of how resilient an investment is under stress.
ICR and lender risk management
From a lender’s perspective, ICR is a key risk management tool. It ensures that rental income is not stretched too thin relative to borrowing. If interest rates rise, landlords with weak ratios may struggle to service debt. By enforcing minimum thresholds, lenders reduce the likelihood of arrears and repossessions. The Bank of England has highlighted the importance of stress testing in preventing systemic risk in the housing market. The interest coverage ratio plays a central role in this approach for buy-to-let lending.
Using an interest rate calculator to estimate ICR
Before applying for a mortgage, landlords may be tempted to use an interest rate calculator to estimate potential payments. While useful, calculators must be used carefully when assessing ICR. Many online tools show payments based on the actual product rate rather than a stressed rate. This can lead to overly optimistic assumptions.
To estimate ICR more reliably, landlords should:
- Use a higher assumed interest rate
- Apply the lender’s required percentage threshold
- Compare rental income against stressed interest costs
This approach provides a more realistic view of affordability and can help avoid disappointment during the mortgage application process.
How landlords can improve their ICR
There are several ways landlords can potentially improve their interest coverage ratio.
1. Increase rental income
This could involve selecting higher-yielding properties. Even relatively small rent increases can have a meaningful impact on the ratio.
2. Reduce borrowing
A lower loan amount reduces interest costs and improves ICR. This may require a larger deposit, but it can make the difference between approval and rejection.
3. Choose a different lender
Different lenders may apply different stressed interest rates and thresholds. A mortgage broker can help identify lenders whose criteria align better with a specific property or tax position.
4. Consider ownership structure
In some cases, holding property in a company may result in more favourable ICR treatment. This depends on tax status and lender policy.
Common misunderstandings about ICR
Many aspiring landlords misunderstand how ICR works. Some believe that rising property values improve affordability. While value matters for loan-to-value ratios, it does not directly affect the interest coverage ratio. Understanding this distinction is important when planning a buy-to-let strategy.
ICR versus cash flow
It is also important to distinguish ICR from actual cash flow. A property may pass lender ICR tests but still deliver modest net income once all costs are considered. ICR focuses only on interest payments, not maintenance, management or taxes. Landlords should, therefore, view it as a minimum hurdle rather than a complete measure of profitability. That said, the interest coverage ratio remains one of the most important gatekeepers in buy-to-let finance.
Conclusion
For aspiring landlords, the interest coverage ratio is a key determinant of whether a buy-to-let mortgage is approved and how much can be borrowed. By understanding how ICR is calculated, why lenders apply stress testing and how thresholds vary, landlords can make more informed investment decisions. A strong ICR not only satisfies lender requirements but also signals a potentially more resilient and sustainable investment.
FAQs
Q. What is the interest coverage ratio?
A. The interest coverage ratio measures whether rental income is sufficient to cover mortgage interest payments based on lender stress testing.
Q. Why do lenders use ICR for buy-to-let mortgages?
A. Lenders use ICR to assess affordability and manage risk if interest rates rise in the future.
Q. What is a typical ICR requirement?
A. Many lenders require 125% - 145%, depending on tax status and risk profile.
Q. Does personal income affect ICR?
A. In most cases, lenders focus on rental income rather than personal income when assessing ICR.
Q. How do stressed interest rates affect calculations?
A. Lenders calculate interest at a higher assumed rate to simulate future rate increases.
Q. Can I use an interest rate calculator to estimate ICR?
A. Yes, but you must apply a stressed rate and the lender’s percentage threshold for reliability.
Q. Why do higher-rate taxpayers face stricter ICR rules?
A. A higher tax rate reduces net rental income, so lenders require a stronger buffer.
Q. Can ICR limit how much I can borrow?
A. Yes, if rental income does not meet the required ratio, the lender may reduce the loan amount offered.
Q. Is a higher ICR always better?
A. A higher ratio indicates stronger affordability and greater resilience to rising costs.
Q. Does a successful ICR test mean that a property is profitable?
A. Not necessarily. ICR only measures interest coverage and does not account for all costs. A property may also decline in value.
Additional sources:
https://www.tembomoney.com/learn/what-is-interest-coverage-ratio
https://theindependentlandlord.com/resources/property-investors-glossary/icr/
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