The Prudential Regulation Authority (PRA) has issued a warning to lenders about correctly assessing affordability in buy-to-let investments.

Recent rental income tax changes have made buy-to-let investments more expensive for higher-rate taxpayers.

The PRA says that they now need more rental income to breakeven, but lenders are not fully accounting for this when assessing affordability.

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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, or a 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, the PRA says 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%.

This means compared to basic-rate taxpayers, lenders are accepting a lower net rental income for given mortgage repayments for higher-rate taxpayers.

All else equal, the PRA suggests this could make lending riskier.

The warning from the PRA suggests that the risk posed by such lending is low at present and the overall quality of buy-to-let lending has improved since 2016.

The PRA has said that they will continue to monitor this risk in buy-to-let lending.