Further curtailment of buy-to-let seems likely following the release of a consultation paper on underwriting standards for the sector.
This follows the chancellor’s decision last year to reduce the tax relief on mortgage interest for buy-to-let investors and effectively reduce the tax allowance landlords can claim for wear and tear. Then came another major blow in the Autumn Statement – the decision to charge an extra 3 per cent of stamp duty on buy-to-let properties. Now the Bank of England’s Prudential Regulatory Authority (PRA) has conducted an investigation into lenders’ underwriting standards for the buy-to-let sector and concluded that some lenders are using looser criteria for buy-to-let borrowing than for ordinary residential borrowing. It believes some lenders “are applying standards that are somewhat weaker than the prevailing market as a whole” and describes its proposals as “a prudent supervisory measure intended to bring all lenders up to prevailing standards”.
The paper proposes that all lenders use an affordability test in assessing a buy-to-let mortgage incorporating the interest coverage ratio (the ratio of monthly rental income to the monthly mortgage payments), and an income affordability test that takes into account any personal income the borrower may use to support mortgage payments. In looking to standardise how these are assessed and calculated the PRA suggests lenders consider all costs associated with renting out the property, such as management and letting fees, insurance, repairs and tax liabilities, and, where the mortgage is supplemented by the borrower’s personal income, lenders must also take into consideration income tax, national insurance, credit commitments, committed and essential expenditure, and living costs. The rent charged must also be assessed by an independent valuer to ensure it is in line with local levels.
Stress test
It also suggests that in assessing affordability lenders should stress test the mortgage over a minimum of five years, based on market expectations, a minimum increase of 2 percentage points in buy-to-let mortgage interest rates as well as any FPC recommendations on stress tests for the sector. Lenders should assume a minimum borrower interest rate of 5.5 per cent. Such proposals, the PRA believes, will help “curtail inappropriately risky and imprudent lending”. It is worried that loans affordable in the current low interest rate environment will become unaffordable if rates rise.
It is also looking to standardise the definition of a portfolio landlord as someone with four or more mortgaged buy-to-let properties in aggregate. The PRA claims to have observed an increase in arrears rates among buy-to-let borrowers with four or more mortgaged properties.
It is concerned about the role of mortgage advisers too. As the sector is largely intermediary driven, it fears lenders with weaker underwriting standards may be adversely selected, resulting in risk being concentrated in their balance sheets. Also, the PRA wants lenders to put in place robust risk management systems and controls appropriate to their buy-to-let portfolios. For example, they should draw up risk management statements covering the identification and mitigation of core risks and monitoring of high-risk segments.
So why put further restrictions on the buy-to-let sector before being able to assess the impact of the changes proposed last year? The FPC predicts a slowdown in the buy-to-let market as the stamp duty changes, which came into effect on 1 April, and the tax relief changes take effect. However, the PRA believes lenders looking for growth in a sector of the market that is slowing down might be tempted to lower their underwriting standards.
Shrink the market
It calculates that, if implemented as they stand, these proposals will result in a reduction in the number of new buy-to-let mortgage approvals by between 10 per cent and 20 per cent. The Chart shows that while the sector has recovered since the financial crash, it has not returned to its pre-crash levels. The proposals are not expected to apply to buy-to-let remortgaging provided there is no additional borrowing.
The paper says the FPC remains alert to a potential threat to the financial stability of the UK’s economy posed by a rapid growth in buy-to-let mortgage lending. It says buy-to-let investors “could behave pro-cyclically, amplifying circles in the housing market, as well as affecting the resilience of the banking system and its capacity to sustain lending in the wider real economy in a stress”.
In other words, it fears buy-to-let borrowers, many on short-term interest-only deals, might rush to sell, if rates were to rise, and trigger some kind of collapse in the housing market, leading to serious consequences for the banking system. These proposals are designed to help insulate lenders, the financial sector and the wider economy from the impact of negative shocks in the housing market. The consultation closes on 29 June 2016.
