What are mortgage stress tests?
The Bank of England has been in the headlines again this week. This time they have released information about plans to scrap the ‘Stress Test’ rule, borrowers must be able to afford an interest rate rise of three percentage points.
This plan to ease mortgage lending rules is aimed at helping a small percentage of people who would otherwise not be able to meet the affordability test. They also state that 6% of borrowers (roughly 35,000 people) could have secured a larger loan if the rule had not have been in place.
Now that’s all well and good, but for many readers it may as well be written in Latin. So, lets break down what this easement means and what ‘real world’ impacts this could have.
Firstly, it’s important to understand what ‘affordability’ means in terms of a mortgage. As you have probably guessed, it is a lenders metric to work out how much a borrower can afford to repay each month. This is worked out by taking the combined salaries of the applicants as well as any commitments they may have to calculate a maximum loan affordable.
Example: Mr & Mrs Claus have a combined salary of £40,000 after tax per annum or £3,333 per month. They budget £1,000 per month for their commitments which leaves them £2,333 per month to pay for a mortgage.
Does this mean that the lender will allow them to take on a mortgage where the repayments are £2,333 per month?
Almost certainly not, but why is this?
This is where the additional layers of affordability tests come into the equation. The main constraint in place is income multiples, which limits most new mortgages to a maximum of 5 times a borrowers’ income. If this rule is applied to the example above, you can start to see just how much this constraint limits lending.
£40,000 multiplied by 5 gives us £200,000 as a potential loan amount. If this mortgage was secured with a 2% interest rate over 30 years, the monthly repayments would be £739 (all the while the interest rate stays at 2%). This is a far cry from the £2,333 Mr & Mrs Claus thought they could initially afford.
At this point it is important to point out that The Bank of England has made no suggestion that the rules surrounding income multiples are going to change and in fact that income multiples limiting loans to 5 times a borrower’s income has been the main constraint on riskier lending according to Andrew Bailey, the Bank’s governor.
So, where does the stress test come in?
The stress test is an additional layer added to the affordability calculation which can also restrict lending. The lender will pose the question, ‘if interest rates dramatically increased during the term of the loan, could the borrower continue to repay the mortgage’. So, in our example they would be looking to see whether a further rise of 3% would have an impact on Mr & Mrs Claus’ ability to repay their mortgage.
In the previous example we worked out that a loan of £200,000 over 30 years with an interest rate of 2% would mean that the monthly mortgage repayments would be £739. If we apply an interest rate of 5% to the same loan the repayments would instead be £1,074 per month. Seeing that the applicants have £2,333 left over each month, they would be satisfied that they could still afford the mortgage despite a spike in interest rates.
It should now be clear that the income multiples act sufficiently as a restriction to lending and that the stress test doesn’t even come close to having an impact on the potential loan amount. This is further backed up by Andrew Bailey’s statement, “We don’t regard it as a relaxation of the rules, rather as an efficiency point, because having now got a body of evidence running back seven years or so now, we are able to take a much more substantial judgment on the effectiveness of the tests”.
In summary, we see this proposed change making minimal impact on the current mortgage landscape and more of a move towards a more efficient way of assessing borrowers’ capacity to cope with changes in interest rates.
If you are curious about how much you could borrow, get in touch with one of our experts to find out.