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What Is Interest Coverage Ratio?

Interest Coverage Ratio in a Nutshell

Banks and non-bank lenders implement various methods to properly evaluate your borrowing power, whether for a commercial or residential loan.

Among them, the most popular way is computing your buying power using Interest Coverage Ratio (ICR) as it excludes tax-deductible expenditures.

Many banks also call ICR a 1.5x or 1.0x interest cover. That’s because it indicates the times your revenue or Earnings Before Interest and Taxes (EBIT) can cover your interest expenses on the given period.

Why is ICR popular in commercial loans?

One of the main factors why ICR is a popular assessment method is because of taxes. An ICR doesn’t factor in tax-deductible expenses such as living expenses for commercial ventures.

But keep in mind that aside from having a strong ICR, you also need to maintain a strong financial position with reliable cash flow.

Regardless of your current position, finding the right lender and negotiating the best deals is possible with a specialist mortgage broker at your back.

Call us at 1300 052 055 and our mortgage brokers will gladly discuss our options and let you know if you qualify.

Why is ICR better than NSR and DSCR?

Unlike ICR, Net Surplus Ratio (NSR) adds living expenditures to the equation, along with your taxes. Hence, computing your borrowing power under this method can be somewhat complex than ICR.

Moreover, the Debt-Service Coverage Ratio (DSCR) is a more obsolete method compared to ICR as it follows a very conservative process when evaluating your borrowing power.

It’s also more applicable for residential loan applications than commercial ones. The DSCR method also assumes that roughly 30% to 50% of your overall income can cover your loan, while another 30% can cover all tax expenses.

The NSR and DSCR are also not ideal for tax-deductible loans and are more useful for assessing residential loan applications.

In other words, only the ICR method makes more sense if you assess your borrowing power from a tax point of view.

How do banks assess my application using ICR?

At the start of every application, lenders and banks will use assessment rates higher than those they provide in commercial loans.

For instance, if you’re applying with a rate of 4.20%, your bank or non-bank lender would assess your application at 7.20% or higher.

They will then compute your available income before taxes under particular percentages. The following is a list of factors that banks consider when using ICR to evaluate your application:

  • Business revenue: 100%
  • Salary: 100%
  • Rental income from investment properties: 80%
  • Income from commercial assets: 65% for landlord-covered outgoings, 85% for tenant-covered outgoings

After computing the above earnings, they will then deduct your expenses from the equation. That includes:

  • Interest payable from your commercial loan using specific assessment rates
  • Interest and principal amounts owed in your existing loans

The ICR assessment method neglects any living expenses and taxes since these are tax-deductible expenditures.

Interest Coverage Ratio Application

For instance, say you’re earning about $90,000 from your company and roughly $65,000 rental income from your property where tenants cover outgoings.

Say you want to apply for a commercial loan at about $1,000,000. If your lender has a variable rate of 4.20% and will use ICR to assess your application, they will increase it to about 8.00% as the assessment rate.

From there, they can begin evaluating your borrowing power. To do so, the bank will divide all expenses before income tax (EBIT) over interest payments.

$155,000 EBIT / $80,000 interest payment = 1.94x interest cover

Now, what does the resulting interest cover say about your application? Is it considered a strong case?

What are strong ICR values?

In general, banks and non-bank lenders want to ensure that you are financially stable and can get away in the face of economic changes or financial difficulty.

The following ICR values will help you determine whether your interest cover is strong enough to get approved for a loan:

  • 0x interest cover: this score will barely pass any application, and only a few banks will consider
  • ~1.3x interest cover: minimum acceptable value for most lenders
  • ~1.5x interest cover: desirable ICR value
  • ~2.0x and higher interest cover: outstanding ICR value and will strengthen your application. This implies you can pay the loan interest twice!
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How a Mortgage Broker can help

 

Our specialist mortgage brokers at Plan A Mortgage can help you find the ideal lender that follows the Interest Coverage Ratio method to evaluate your application.

That way, you can maximise your borrowing potential and get approved for better deals and loan features that best suit your needs.

Feel free to speak with us at 1300 052 055 or fill out our contact form to discover if you qualify for a commercial loan today!

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