Holiday Let Mortgages: Interest Cover Ratio

What is Interest Cover Ratio?

Interest Cover Ratio (ICR) is a rental-focussed affordability calculation; a test done by mortgage lenders to give them a view on how much a person can safely borrow when it comes to holiday let mortgages.

When you buy a residential home, the mortgage lender will assess your affordability by looking at your income and outgoings after tax, in order to calculate your disposable income. The lender will want assurance that you have enough money to afford your mortgage and cover your monthly mortgage payments. When it comes to buying a holiday let and the lender’s ICR calculation, things are slightly different.

ICR and holiday let mortgages

Because a holiday let property is a revenue-generating asset (unlike the home that you live in that doesn’t normally make any money), it is viewed as an investment purchase which you rent out to make a profit.

As a result, with holiday lets, a lender will underwrite your mortgage application and calculate the ICR not on your personal income, but upon the property’s projected gross rental income.

The aim is to look at the holiday let’s rental income and compare it to how much the mortgage interest will be, with the interest rate set to a higher-than-normal level (the “stress test”) to give the lender some headroom.

By doing this, the mortgage lender can satisfy themselves that the amount of money generated by the holiday rental (after you have reduced it a little bit) will cover the interest payment on the mortgage by a certain amount.

Look at it like this: the mortgage provider is potentially going to lend out £100,000 on a holiday let property. They will want to be confident in the knowledge that the holiday let’s gross rental income will not just cover the interest on the mortgage, but cover it twice or three times over, thus giving them more security to their loan.

What are the components of the ICR calculation?

ICR is a standard calculation made upon mortgage applications. With a new holiday let property that hasn’t been rented out before, you will need a “mortgage letter” from a reputable holiday letting agency (such as holidaycottages.co.uk) which should state a gross income forecast, expected number of bookings per annum plus an estimate of the low, medium, and high weekly rental rates.

A typical letter will look like this:

“Roseland Cottage in Blockley, The Cotswolds, will generate £25,000 of gross rental income over 30 bookings. The low weekly income rate is £400, the medium rate is £600, and the high rate is £800.”

Example mortgage letter

These figures must be provided to the mortgage lender and each different lender will have their own version of the ICR calculation.

The mortgage lender will add up the low, medium, and high rental rates and divide by three to make an average rate. They will usually then multiply this figure by the number of weeks or bookings mentioned in the mortgage letter, or the number 30.

The reasoning behind making this calculation is to take into consideration the fact that the holiday let property is unlikely to be rented out for 52 weeks of the year; 30 weeks is a much more reasonable amount. 30 divided by 52 is around 60% occupancy – the mortgage lender is effectively making an educated assumption around occupancy level.

Once the lender has done these calculations, they will have a figure of their predicted gross rental income. From this, they will do a “stress test”.

What is the stress test?

Once the lender has a figure for the holiday let’s gross rental income, they will use it to determine how much money they’re willing to lend to the buyer. Importantly, the mortgage lender will want the loan to cover an interest rate of a certain percentage that is stressed to be higher.

What the lender does is to pick an interest rate – usually either the current rate plus 2% or a calculated rate such as 8% – and stress it further; in other words, bump the interest rate higher to make it slightly worse, as this offers more protection against their loan. Normally, the lender will stress the selected rate at 145%.

In figures for example, if the interest rate is 10% you would multiply this by 145% to get the stressed rate of 14.5%. The idea is that the mortgage provider lends an amount of money, such that the rental income is the equivalent to what 14.5% interest rate would be. This is how the mortgage lender calculates the maximum amount of money they will lend on a holiday let property.

How does this work in figures?

To help understand the above with numbers, the following are worked examples from three top building societies. Let’s assume the following basics around our transaction:

Purchase Price	£350,000
Loan Required	£250,000 (71.4% LTV) with an initial period of two years
Letter from holiday letting agency states: Low season = £700; Medium season = £900; High season = £1,100. Annual gross rental income of £32,000

Principality:

Principality’s mortgage lending criteria at the time of writing this article (May 2023) states:

“Rental income is calculated using an average of the projected low, mid and high season weekly rental yields. This is usually multiplied by an assumed occupancy level of 30 weeks then applied to the rental coverage calculation as follows: 145% @ 6.65%”

So, using our numbers in our table above, the maximum Principality would lend is:

Assumed gross rental income calculation
Low £700 + medium £900 + high £1,100 = £2,700	Average income: £2,700 / 3 = £900	Assumed gross income with 30 weeks’ occupancy:  £900 x 30 = £27,000
Maximum loan calculation
Gross rental income £27,000	Stressed interest rate 145% @ current rate 6.65	(£27,000 / 145 x 100) / 0.0665 = £280,010 maximum loan

Principality could potentially lend up to £280,010 which is greater than the required loan of £250,000, so this buyer would pass the ICR test.

Cumberland:

Cumberland’s mortgage lending criteria at the time of writing this article (May 2023) states:

“To meet our criteria for rental coverage, annual net rental income (we assume 80% of the gross figure) must:

• For product terms of less than 5 years the annual rental income should be a minimum of 125% of the annual mortgage interest calculated using the rate of 5.5% or product rate + 2%, whichever is the highest.
• For product terms of 5 years or more the annual rental income should be a minimum of 125% of the annual mortgage interest calculated using the rate of 4.5% or product rate + 1%, whichever is the highest.”

So, using our numbers in our table above, the maximum Cumberland would lend is:

Assumed gross rental income
Cumberland does not use the low, medium high approach, but takes “80% of the gross figure” in the mortgage letter. Therefore, £32,000 x 80% = £25,600
Maximum loan calculation
Gross rental income £25,600	Stressed interest rate 125% @ current rate of 5.78 % + 2%	(£25,600 / 125 x 100) / 0.0778 = £263,239 maximum loan

Cumberland could potentially lend up to £263,239 which is greater than the required loan of £250,000, so this buyer would pass the ICR test.

Buckinghamshire:

Buckinghamshire’s mortgage lending criteria at the time of writing this article (May 2023) states:

“For purchases, rental income is calculated as being the average of the low, medium and high weekly rates, multiplied by an assumed occupancy figure of 60% of the year (so, 52×60% = 31 weeks) less 24% for agency costs inc VAT. This income level is then stress tested at 125% @ current rate +2.5%” 

Assumed gross rental income calculation
Low £700 + medium £900 + high £1,100 = £2,700	Average income: £2,700 / 3 = £900	Assumed gross income with 31 weeks’ occupancy: £900 x 31 = £27,900 less 24% agency fees = £21,204
Maximum loan calculation
Gross rental income £21,204	Stressed interest rate 125% @ current rate of 5.5% + 2.5 %	(£21,204 / 125 x 100) / 0.08 = £212,040 maximum loan

Buckinghamshire could potentially lend up to £212,040 which is lower than the required loan of £250,000, so this buyer would not pass the ICR test. The maximum loan possible is limited to £212,040.

How can HCM help?

If you’re looking for more information about getting a holiday let mortgage and the ICR calculation, we can help. HCM has extensive knowledge about ICR, and experience making those all-important calculations, which let’s face it, can be tricky!