The recent confirmation that the Bank of England is planning to relax its mortgage affordability tests appears to be good news to those looking to buy a property as they may be able to borrow more money for their purchase. However, what does this really mean for buyers?
Currently, lenders will use two separate tests to decide how much someone can borrow to buy a house: a loan-to-income limit and an affordability test. These were introduced by the Financial Policy Committee (FPC) in 2014 to “guard against a material increase in household indebtedness that could potentially make an economic downturn worse”.
The Loan to Income (LTI) ratio test limits how many mortgages can be offered at ratios at or above 4.5% to 15% of a lender’s new mortgage lending.
The affordability test (which is what is currently under discussion) gives a “stress” interest rate that the lender will use to check if the applicant would still be able to pay should it reach this point. In other words, it tests if the borrower would be able to make their mortgage payments should the reversion interest rate (the rate you go on to at the end of a fixed rate term) rise by 3% above the standard variable rate at any time in the first five years of borrowing. Essentially, while most product rates are still low, it’s working out if buyers can afford an expensive mortgage before they are offered a cheap one.
Following analysis that suggests that the current affordability test may have caused nearly 30,000 borrowers a year to be offered smaller mortgages, the Bank of England has now launched a consultation on withdrawing the test, but will keep the Loan-to-Income test as it should “deliver an appropriate level of resilience to the UK financial system, but in a simpler, more predictable and more proportionate way”. It is “likely to play a stronger role than the affordability test in guarding against an increase in aggregate household indebtedness and the number of highly indebted households when house prices rise rapidly”.
Despite falls in interest rates in recent years, the Bank of England says that the affordability test “has remained broadly static”, which “demonstrates that there is considerable uncertainty about how the stress rate encapsulated in the affordability test might move in future, and in turn about the effect the test could have.”
Responsible lending rules that are already in place under the Financial Conduct Authority’s Mortgage Conduct of Business (MCOB) “would remain as an appropriate affordability check”. The Bank of England stated: “A lender must also assume that interest rates rise by a minimum of 100 basis points during the first five years of the mortgage.
In theory then, this should be good news for potential buyers as they may be able to borrow more towards their dream home. However, removing a limit on large mortgages while house prices are already high and the future is so uncertain, may allow more borrowers to over-stretch themselves to buy a better property. This could put them at risk of negative equity should the current house price bubble burst. On the flipside, there are also concerns that the move could push house prices even higher making it even harder for first time buyers to get on the property ladder.
In reality, though, with rising inflation pushing the cost of living up, lenders are already being more cautious and want to ensure any mortgage they approve will remain affordable for the borrower. Many lenders have recently changed the calculations they are using to consider these rising costs. This could mean that lenders’ own affordability tests become more stringent and actual loan amounts are lower than previously, therefore cancelling out any real benefits from the proposed change should it be passed.
The consultation will end on 6 May 2022 and if it is decided to withdraw the affordability test, it is expected to take effect within 12 months.