Buy-to-let lenders should brace themselves for tighter controls on mortgage lending. The Prudential Regulation Authority (PRA) is proposing to introduce minimum standards firms should meet when underwriting buy-to-let mortgage contracts covering affordability testing, stress testing and more robust risk management. Input is being sought on these proposals by 29 June 2016. This briefing looks at the key changes being proposed by the PRA.
1. Industry review of buy-to-let underwriting
A recent industry review carried out by the PRA raised concerns about underwriting standards in the buy-to-let sector. The survey of lending plans of the top 31 lenders revealed:
- the potential for strong growth in the industry, with firms planning to increase their buy-to-let lending by an average of almost 20% per annum over the next two years;
- less rigour in underwriting standards than the market norm; and
- a failure by the majority of lenders to account for the forthcoming changes to landlord mortgage tax relief in their affordability assessments.
The PRA published a consultation paper (CP 11/16) in March 2016 which puts forward recommendations designed to preserve the integrity of buy-to-let lending decisions. In the face of market growth, the proposals "aim to prevent a marked loosening in buy-to-let underwriting standards and to curtail inappropriate lending and the potential for excessive credit losses".
There are five key proposals, discussed in further detail below. These would apply to PRA-regulated firms which undertake buy-to-let lending that is not already subject to FCA MCOB regulation or the new consumer buy-to-let regime. Importantly, these proposals will capture buy-to-let lending to limited companies. The PRA will also expect regulated firms to ensure that other members of their group apply these standards when carrying on buy-to-let lending.
2. Key proposals
2.1 Affordability testing
The PRA proposes that all firms use an affordability test when assessing a buy-to-let mortgage contract. This can take the form of an interest coverage ratio to assess whether the projected rental income from the property is sufficient to cover mortgage payments. Alternatively, where the personal income of a borrower is contributing to monthly payments, a personal income affordability test will be required.
The consultation paper envisages an industry wide set of variables for these affordability tests. This will standardise the factors considered and aim to ensure firms are prudent in their lending decisions. Factors include:
- an independent valuation of rental levels and rental demand in the property locality;
- all costs associated with renting the property for which the borrower is responsible including letting fee, repairs and voids;
- the tax liability connected with renting; and
- where personal income is used to support mortgage payments, a host of borrower considerations including evidence of personal income net of income tax liability, national insurance payments, credit commitments and living costs.
The proposals do not go so far as to suggest specific guidance for loan-to-value standards but the message of greater accountability follows through, with the PRA expecting to see firms putting appropriate controls in place to mitigate the risk of higher loan-to-value lending.
2.2 Interest rate stress tests
Firms should assess, and take account of, likely future interest rate rises. Under the proposals, lenders will need to consider whether borrowers could still afford mortgage payments over a period of five years if interest rates were to rise. In making this assessment a lender must, amongst other things:
- consider market expectations, having regard to a minimum increase of two percentage points in buy-to-let interest rates as well as external sources of data such as the Bank of England forward setting rate;
- create and adhere to a written policy; and
- be able to justify its calculations.
The proposals indicate that interest rate stress tests should be subject to a minimum stressed interest rate of 5.5%.
2.3 Portfolio Landlords
Borrowers with four or more mortgaged buy-to-let properties will be considered 'Portfolio Landlords'. This type of lending is considered more complicated and risky than standard lending as a result of higher aggregate levels of debt and risks associated with the borrower owning a geographic concentration of properties. The PRA proposes a specialist underwriting procedure for this group of borrowers. Amongst other factors, lenders will need to assess the borrower's experience in the buy-to-let market, historical and future cash flows and their business plan.
2.4 Risk Management
Lenders will be expected to operate their buy-to-let lending in accordance with robust risk management systems and controls which will identify, manage and monitor core risks. In particular firms will be expected to have appropriate oversight and monitoring of business introduced by intermediaries.
2.5 The SME Supporting Factor
The 'SME supporting factor' is a rule which, where applicable, can be used to reduce capital requirements on loans to SMEs by around 24%. The consultation paper clarifies that in most cases the PRA does not consider buy-to-let borrowing to fall within the intention of the SME supporting factor. It should therefore not be applied where the purpose of the borrowing is to support buy-to-let businesses.
3. Next Steps
These proposals if implemented in their current form may well have a significant impact on the market as affordability assessments for the unregulated buy-to-let sector will be more in line with those seen in the regulated mortgage market.
The consultation closes on Wednesday 29 June 2016 and any feedback on the consultation paper should be submitted to [email protected] before the closing date.
This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.
© Farrer & Co LLP, May 2016