How Lenders Assess Rental Income
What do lenders look at with rental income for mortgages? This makes financial sense for lenders to ensure borrowers can consistently make repayments.
The Calculation
How do lenders include rental income? Some may take as much as 80% of gross rental income, while others may insist on it covering 125% of the mortgage repayment. So if your mortgage payment is £800 a month, lenders might want your rent to bring in £1,000 or more.
Rental yield (annual rent/property value) matters. A property worth £200,000 with a £12,000 annual rent, for example, yields 6%. Higher yields typically render borrowing more practical. Lenders will apply rental valuations to calculate potential income, particularly for properties which have not yet been let.
Rental income is typically included with household income for affordability tests. So, for example, if you earned £30,000 a year and rental income made up £10,000, £40,000 would be the income taken into consideration. Some lenders may multiply this total by 4.5 or even five to work out borrowing capacity.
Tenancy Agreements
Legitimate tenancy agreements are key. Lenders usually expect legally compliant, signed contracts as evidence of continued rental. Emphasising long-term contracts, including a two-year lease, calms lenders’ concerns over stable income.
These arrangements must be substantiated with evidence, such as bank statements showing rent payment. For example, demonstrating regular £1,200 deposits monthly bolsters the application.
Your Experience
Experience as a landlord lends credibility to mortgage applications. Borrowers who have multiple properties or have a tight rental income remained reliable, even in volatile markets.
Proof of good tenant management, like dealing with disputes or keeping properties well maintained, bolsters applications. For example, demonstrating your portfolio has high occupancy levels can boost lenders’ confidence.
Property Type
The kind of property impacts lender criteria. Residential property such as houses/flat will be prefered over commercial or non-standard buildings. A thatched roof, for example, may require niche lending requirements.
Supporting Documents
Bank statements proving rental deposits, SA302s and evidence of ownership are crucial. An income and expense statement, detailing outgoings like maintenance, provides visibility, guiding lenders’ decisions.
Navigating Lender Stress Tests
Lender stress tests are supposed to determine a customer’s ability to afford mortgage repayments in various financial circumstances. For buy-to-let mortgages, they examine how resilient your rental income, as well as your personal finances, is to fluctuations in interest rates or market changes. Knowing how these tests are calculated can help you improve your chances when you are applying for a mortgage.
The PRA Rules
The PRA’s rules are the ones lenders have to follow to stress test rental income mortgages. These rules mean lenders must ensure rental income is enough to pay the mortgage – at least 125% of the payment. Some lenders will stretch this further, seeking as much as 145% for more stringent stress-testing scenarios.
For those with multiple properties, the PRA has further requirements. Portfolio landlords (those with four or more mortgaged properties) have stricter stress test thresholds. That means a thorough examination of every one of the portfolio’s properties and the income they generate. Borrowing caps can be restricted, with lenders calculating the overall financial exposure of various loans.
The Interest Rate
Interest rate movements are central to stress tests. Lenders stress test rates hikes, meaning that borrowers are still able to afford payments if rates surge. Fixed-rate mortgages can be more predictable in these circumstances, whereas variable-rate ones bring greater uncertainty.
So, if a lender stress tests at a rate of 6%, they will work out if your rental income can pay the mortgage at this elevated rate. A handful of lenders have lowered their stress test rates lately, letting landlords borrow more. Make sure your rent still stacks up under these forecasts, particularly for interest-only deals.
Your Portfolio
Owning several properties makes things more complex for stress tests. They will look at your overall portfolio management, considering things like rent roll, who you owe money to and how much leverage you have. Emphasising stable rental yields and showing a diversified portfolio can increase your approval chances.
If you’re dependent on debt, this may set alarm bells ringing. Tackling high leverage through paying down your mortgage or increasing deposits may be […] Landlords that haven’t reviewed rents in years may need to raise them to shore up their finances.
Boosting Your Borrowing Power
With buy to let mortgages, enhancing your borrowing power is the key to getting the best deal and making the most of your investment. This is affected by a number of things, from your finances to how you handle your investments.
Boosting your rental income is an important first step. The distillation of the class has the surprising advantage of being attractive to tenants, and the higher the rent, the more borrowers can expect. Simple upgrades, like new paint, contemporary fixtures or energy-efficient appliances can do wonders. For example, a house next to decent transport links or schools in London or Manchester typically attracts higher rents. Bear in mind though that lenders usually want rental income to be 25% to 45% more than the monthly mortgage payment to ensure affordability.
Paying down any outstanding debts is important. Lenders consider affordability based on all your commitments. Clearing credit card balances or reducing personal loan repayments can improve your debt to income ratio. It makes you a more appealing borrower to lenders, particularly if you’re seeking a competitive buy-to-let mortgage with an average deposit of 15% or more.
Saving for a bigger deposit can unlock better mortgage offers. A larger deposit not only decreases the amount you need to borrow, it enables you to qualify for cheaper interest rates. For instance, you’ll typically need 25% or more as a deposit to get the best buy-to-let deals. Or if you have equity in a separate property, you could borrow against that to supplement your deposit – although this is a risky move that puts more than one property at stake.
Lastly, go joint ownership. Pool your income with a partner or co-investor, and your borrowing power will be much higher. This is particularly helpful if your personal income is low, as lenders take account of earnings from rental properties, pensions or salaried work. Using multiple properties as collateral could allow for even more borrowing, but always consider the threat of repossession.
Declaring Rental Profit to HMRC
If you receive rental income from UK property, you’ll need to inform HMRC. Which means filling in the UK property pages of your tax return . . . Or the foreign pages if it’s overseas. Even if you don’t already get a tax return, you’ll have to inform HMRC of your rental income by 5 October after the end of the tax year. Making sure you keep records for at least six years is vital to meet HMRC’s audit requirements.
The Cash Basis
Cash basis makes reporting rental income tax much easier. This approach records income and expenses when the money is actually received or paid, so you don’t have to faff around with accrual accounting. So if your tenant pays rent in March when it’s due in February, you only declare it for March under the cash basis.
This approach is ideal for landlords with uncomplicated property businesses. It’s only accessible if your rental income is under £150,000 per year. Be sure to hit that threshold before you opt in!
Traditional Accounting
Traditional accounting gives you a wider picture of all your financial dealings. In these cases, income and expenses are registered as they are earned or incurred, regardless of when payment occurs. For example, unpaid rent or outstanding maintenance bills still need to be accounted for in your tax calculations.
This approach is perfect for landlords earning more rent than the cash basis threshold. While it requires slightly more record-keeping, it gives you a clearer picture of your rental business’ finances. It’s very handy if you have more than one property or have a complicated income stream.
Joint Ownership
If you have shared ownership of the property, then rental income and costs will need to be divided based on your percentage share of it. Each owner then declares their piece of the taxable profit separately, to take advantage of individual tax allowances. E.g.) if two owners have 50/50 ownership, each declares 50% of the rental profit.
Clear agreements are key to avoiding disputes. This will not only keep you on the right side of HMRC, but can be a more efficient use of tax, particularly if owners are in different tax brackets.
Allowable Expenses and Reliefs
If you’re running rental income mortgages, knowing what expenses and reliefs are allowed could lower your tax bill by a lot. Identifying qualifying costs correctly keeps you compliant and gets the finances sorted!
Day-to-Day Costs
Standard running costs involved in renting out a property are deductible. Such expenses include gas, electricity and water rates, council tax, insurance premiums and agent fees for property management. Landlords need to retain invoices for these as they are the spinal column of allowable deductions.
Repairs and routine maintenance like a leaky tap or touch-up painting too. These costs must be directly associated with preserving the property’s state of affairs, rather than improving it. For instance, swapping out a broken boiler would be an allowable expense.
It’s essential to stay on top of these costs. Receipts and invoices are proof that your deductions are real and can be justified when reporting taxes.
Repairs vs Improvements
Repairs return a home to its original state and are 100% deductible. So for example, a new roof or electrical repairs would qualify. Upgrades or improvements – extending a property, or fitting a new kitchen to boost value, for example – count as capital expenditure and aren’t deductible as trading expenses.
It’s vital that you distinguish between repairs and improvements. For instance, new worn carpets may be deductible but pricy hardwood flooring for decoration is not. Always make sure you document your expenses clearly to avoid confusion or disputes with HMRC.
Finance Cost Relief
Reforms from April 2020 restrict relief on residential property finance costs to the basic taxpayer level. Landlords can’t deduct all mortgage interest, either, with a 20% tax credit available on finance costs. This covers mortgage interest and associated fees, such as arrangement fees.
To plan accurately, landlords must work out allowable relief on net rental profits. Remember that losses on one property write off profits on another, and that can affect the wider tax position.
Property Allowance
The property allowance allows £1,000 of tax-free rental income per year. This is attractive to smaller landlords with few costs. If you claim this allowance, then real costs can’t be deducted too.
The Landlord’s Ledger: Essential Record Keeping
Accurate and well-organised records are at the heart of managing rented properties effectively – especially so with rental income mortgages. Proper record keeping is vital for landlords to be on top of their finances, comply with tax obligations and facilitate audits. Rent ledgers are a simple device, providing a straightforward overview of income, expenses and balances.
This includes tracking rental income and expenses. A proper rent ledger usually has columns for rent due, extra rent taken, with any remaining balance. This detailed approach is invaluable for landlords who want to keep tabs on their cash flow and spot any problems. Partial payments or additional repair costs can be recorded in an orderly manner for easy identification of trends or resolving quarrels.
Digital tools and spreadsheets are must-haves for efficient financial monitoring. Software like landlord-specific apps, or even Excel sheets, can do the sums for you, taking out the guesswork. As HMRC moves more and more towards digital tax systems, using these tools not only makes management simpler but keeps landlords ahead of the game. Routinely maintaining records avoids mountains of paperwork and keeps the ledger in sync with real-time finances.
Just as importantly, you’ll need to keep hold of important documents including receipts, invoices and tenancy agreements. These are required for substantiating costs and revenues. For example, a receipt for a repair could back up a claim during a tax return. Landlords should maintain comprehensive records of conversations with tenants, tradesmen and letting agents as these can help provide context and clarity in the event of disputes. Tax records have to be held for a period of normally a minimum of six years, or longer depending on the business structure or other legal obligations.
Easy to access, well-maintained records make preparing for HMRC audits simple. In the event of an audit, and they do happen, landlords must be able to clearly prove their income and expenses, so a neat and tidy system makes sure they’re prepared should the need arise, bypassing headaches.