The interest coverage ratio (ICR) is a financial metric used to assess a company’s ability to pay interest on its outstanding debt. It is calculated by dividing a company’s earnings before interest and taxes (EBIT) by its interest expenses for the same period. The formula is:

Interest Coverage Ratio=EBITInterest Expense\text{Interest Coverage Ratio} = \frac{\text{EBIT}}{\text{Interest Expense}}Interest Coverage Ratio=Interest ExpenseEBIT​

Importance of the Interest Coverage Ratio

1. Liquidity Indicator: The ICR measures how easily a company can cover its interest payments with its operating earnings. A higher ratio indicates a greater ability to meet interest obligations, while a lower ratio suggests potential difficulty in covering interest payments.
2. Creditworthiness: Lenders and investors use the ICR to evaluate the financial health and creditworthiness of a borrower. A higher ICR generally indicates a lower risk of default, making it easier to secure loans and attract investment.

Application to Buy-to-Let Property in the UK

For buy-to-let (BTL) property investments, the interest coverage ratio is particularly relevant. In this context, the ICR is used to assess a landlord’s ability to cover mortgage interest payments with rental income. Here’s how it works and its impact on buy-to-let property:

1. Calculation for Buy-to-Let:
   • For buy-to-let properties, the ICR is often calculated as the ratio of rental income to mortgage interest payments. Some lenders might also include other expenses in the calculation.
   • Example: If a property generates £10,000 in annual rental income and the annual mortgage interest payment is £5,000, the ICR would be: ICR=Rental IncomeMortgage Interest Payments=£10,000£5,000=2\text{ICR} = \frac{\text{Rental Income}}{\text{Mortgage Interest Payments}} = \frac{£10,000}{£5,000} = 2ICR=Mortgage Interest PaymentsRental Income​=£5,000£10,000​=2 This means the rental income is twice the mortgage interest payments.
2. Lender Requirements:
   • Lenders typically have minimum ICR requirements for buy-to-let mortgages to ensure that the rental income can sufficiently cover the interest payments. This threshold varies by lender and can range from 125% to 145% of the mortgage interest.
   • For instance, a lender requiring a 125% ICR would want to see rental income that is at least 1.25 times the mortgage interest payment.
3. Impact on Loan Approval and Amount:
   • A higher ICR can improve the chances of loan approval and may also enable the borrower to secure better loan terms, such as a lower interest rate.
   • Conversely, if the ICR is too low, the lender may consider the buy-to-let investment too risky and could either deny the loan application or offer a smaller loan amount.
4. Stress Testing:
   • Lenders also use stress testing to assess the robustness of the ICR under different interest rate scenarios. They may simulate higher interest rates to ensure that the borrower can still cover interest payments if rates rise.
5. Tax Considerations:
   • Recent changes in UK tax laws affecting mortgage interest relief for landlords have made the ICR even more critical. From April 2020, landlords can no longer deduct mortgage interest payments from rental income before calculating their tax bill. Instead, they receive a tax credit based on 20% of the mortgage interest payments. This change can impact the effective ICR and the overall profitability of buy-to-let investments.

Conclusion

The interest coverage ratio is a crucial metric for assessing the financial viability of buy-to-let property investments in the UK. It helps lenders evaluate the risk associated with lending to landlords and ensures that rental income is sufficient to cover mortgage interest payments. Understanding and maintaining a healthy ICR is essential for securing financing and managing the financial stability of a buy-to-let property portfolio.