Our latest instalment of Mortgage Language Lessons - Interest Cover Ratio (ICR). Loan serviceability requirements imposed by a lender can mean as much or even more than the interest rate alone.
When business are looking to borrow money, the main issue for the lenders is obviously their ability to recover both the 'principal' (the amount of money borrowed) and the 'interest' (the amount of money the lender is going to charge you for the pleasure of having their money - over and above the principle).
Depending on the nature of the loan (e.g. investment property purchase, construction loan, business purchase loan etc.) interest can be usually be payable in one of two ways. In some circumstances, the lender may allow the borrower to 'capitalise' the interest. This means the lender will allow the interest charges to be tacked onto the entire loan amount and paid back in a lump some. This means that no interest invoices would be payable on a regular recurring basis (i.e. monthly) throughout the life of the loan. Rather, at an agreed time (such as at the completion and sale of a construction project) the borrower is simply required to pay back the principal and all the interest that has built up since the inception of the loan.
This a great way to borrow as it doesn't require the client to have to worry about finding money to make repayments every month.
Alas, many lenders do not accept capitalised interest on a range of their products. In a case where interest cannot be capitalised the loan must be 'serviced' on a regular basis i.e. the borrower must make payments each month throughout the loan term.
These loans can only be secured if the borrower can prove that they have the required cash flow to make the monthly payments. Whether these payments consist of interest only or a combination of interest and principal repayments may also be determined the exact circumstances of the finance.
In order to establish serviceability lenders will not be satisfied there is just enough income to make repayments. Lenders are aware that companies and individuals have myriad expenses and can't assume that those expenses will make way for loan repayments automatically. This means lenders require borrowers to prove income beyond the amount required strictly for servicing.
This amount is known as Interest Cover Ratio or ICR and is basically expressed as a multiple of the loan repayment amount. For example if a client borrows $1 million at an interest rate of 2% over a 5 year term then the total amount to be repaid would be $1.1 million, or $220,000 annually, roughly $18,350 per month.
If a lender requires an ICR of 1.5x (1.5 x $18,350 per month) the borrower would need to show at least $27,525 worth of regular income. In most cases lenders will require an ICR of between 1.5x-3x on average. The more conservative the lender (read big 4 bank) the higher the ICR requirements are likely to be.
Make sure you speak to your broker or lender about ICR requirements before applying for any loan. Loans are made up of a range of factors that must be considered above and beyond the interest rate. In some cases it may be more beneficial to borrow at a higher interest rate where ICR requirements are less onerous or even where interest can be capitalised rather than at a lower interest rate with more stressful conditions.
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