Borrowers left exposed by mortgage stress tests that weren’t required to factor in inflation
Insufficient stress testing could have left mortgage holders exposed to rising interest rates, experts have told i.
Lenders were not required to factor inflation into their affordability checks for mortgages, meaning that some borrowers could struggle to make repayments as interest rates rise on top of the cost of essentials.
The average interest rate for a two-year fixed rate mortgage has hit 6 per cent and Britain is currently experiencing the highest core inflation rate for three decades – 8.7 per cent – for longer than was expected, while essentials such as food have an even higher inflation rate of 18.4 per cent.
While many mortgage lenders will have stress-tested their customers’ ability to repay loans at 6 or 7 per cent, they may not have factored in their ability to repay mortgages against the backdrop of such high living costs, experts say.
Last year, the Bank of England scrapped the mortgage market affordability test which forced banks to be sure that mortgage borrowers could afford a 3 percentage point rise in interest rates before they could be approved for a home loan.
That test was introduced in 2015 – when interest rates were still historically low in the wake of the 2008 global financial crisis with the intention of preventing a housing bubble from forming – to make sure that borrowers could afford their mortgages at a “stress” rate of 3 per cent over the standard variable rate (SVR). This meant that borrowers were tested at 6.5 or 7 per cent, even though they might only have been paying 1 or 2 per cent.
This rule did not require lenders to factor inflation into their stress tests. It ended in July 2022 because the Bank felt that new Financial Conduct Authority (FCA) regulations “offered the same resilience”.
However, while FCA, the regulator, has requirements for stress testing, it is up to individual lenders to decide how they measure what their customers can afford, and those requirements also do not force them to factor in the high inflation Britain is currently experiencing.
Richard Donnell is the executive director of the property listing website Zoopla. Prior to that, he worked for the estate agency Savills.
“The Bank of England clearly needed a better crystal ball in 2015,” Mr Donell told i.
The FCA’s rules (known as MCOB – the Mortgage Conduct of Business), for example, require that lenders check that their customers can afford payments at an interest rate at least 1 per cent higher than the rate it will go to at the end of their fixed-rate deal (known as the reversion rate) as well as carry out income and expenditure assessments, but there is no mention of factoring in inflation.
Mr Donell told i that “the disconnect” has happened because “the Bank of England’s affordability threshold was scrapped and, instead, we have been testing people at standard variable rates plus 1 per cent”.
“There will be some people for whom this testing wasn’t sufficient in the current climate, we don’t know how many people will be adversely affected by rising rates yet,” he added. “Affordability testing seemed draconian at the time and priced many young people out of home ownership. But, with mortgage rates rising toward 6 per cent and rise in the costs of living, some people are now questioning whether it went far enough.”
“The big impact of rising rates will be on those who bought recently at higher loan to values and high loan-to-income ratios. Many older homeowners with smaller mortgages will be less impacted.”
Expert housing market analyst Neal Hudson told i that it is “a black box process” so we don’t know “exactly what lenders have done”.
“I wonder how many mortgage stress tests assumed food inflation would be this high?” Mr Hudson said.
“We can see the numbers that go in and the decision that comes out the other end, but we’ve got no idea what the processes are internally or how they figure out how a customer can afford a loan or not,” he added.
“It’s all very secretive because no bank wants another bank to find out about their lending decisions because that’s how they operate in the market.”
Britain’s housing market has a problem, says Mr Hudson. It is that the low interest rates experienced after 2008 became “priced in” to the housing market in the 2010s as cheap credit-fuelled historic house price increases.
“The rules may have stopped a mortgage bubble forming but they didn’t stop our reliance on record low rates,” Mr Hudson told i. “The current strain on mortgage holders was an inevitable consequence of keeping mortgage rates low and when rates went back up, it was always going to be a problem. You didn’t need a crystal ball to see that.”
As the cost of everything rises, real wages (that’s your income adjusted for inflation) have fallen.
Rachelle Earwaker is a senior economist at the Joseph Rowntree Foundation (JRF), an independent organisation that researches poverty.
Ms Earwaker told i that the strain of rising mortgage rates is very real as living costs rise but real wages do not.
“New JRF analysis of the cost of living has found that over four in ten low-income mortgage holders are currently spending more than 40 per cent of their income on monthly repayments,” she said.
If housing costs exceed a third of someone’s take-home pay, they are considered unaffordable.
According to the JRF, there are 1.7 million low-income households with a mortgage in Britain – that means over 700,000 households are struggling already.
This number could grow, Ms Earwaker warns, because “31 per cent of low-income mortgage holders say their fixed-rate mortgage will come to an end between now and the end of the year – and a large number of this group is already spending more than 40 per cent of their income on their mortgage. It’s a very concerning sign”.
The Bank of England is currently raising their base interest rate in an attempt to dampen inflation.
Ms Earwaker said that there is no requirement for the Bank to consider what the impact of their actions might be on the housing market or on mortgage holders.
“In other countries that’s not the case,” Ms Earwaker explained. “In New Zealand, for instance, considering the impact of rising rates on the housing market is part of the central bank’s remit.”
“The housing market is such a big part of Britain’s economy, the Bank of England will of course be considering the impact of rate rises on mortgage costs and house prices, but it’s also clear in the UK that their job when setting interest rates is to focus entirely on getting inflation back to the 2 per cent target,” Ms Earwaker added. “In the Bank’s eyes, it’s for the government to respond to the fall-out from higher rates, tricky as that might be.”
The Government did not expect inflation to stay so high for so long. Earlier this year, Rishi Sunak promised to halve it by the end of the year. However, Britain is currently experiencing higher headline inflation than other European countries – reasons for this include the fact that much of our housing stock is poorly insulated, that Brexit has added to delivery times and costs for UK imports, shortages of certain food items such as tomatoes and cucumbers due to cold weather in Spain and Morocco and worker shortages in some places leading to higher wages for those who are available, which feeds back into inflation.
It is unlikely that the current mortgage rates crisis will result in the same number of repossessions seen in the 80s and 90s because banks are encouraged to engage in forbearance now such as lengthening mortgage terms and allowing customers to switch to interest-only, but Britain’s housing market nonetheless remains in a tight spot.
House prices hit historic highs throughout the pandemic, peaking in 2022. This means that people borrow more as a share of their income to buy homes today. The effect of that is that today’s mortgage rates will cause the same amount of stress as double-digit rates did in the 1980s.
A Bank of England spokesperson directed i to the Bank’s financial policy committee’s decision on removing the affordability test.
So, what should lenders and the FCA have done differently?
“The loan-to-income soft cap should have been lower than 4.5 x income,” Neal Hudson tells i. “Banks shouldn’t have been lending as high loan-to-income multiples as they were. We are already seeing those multiples coming down, the typical multiple has been heading back to 2015 levels (3 x income) and will soon reach 2007 levels (2.8 x income).”
An FCA spokesperson told i: “Our affordability rules mean that lenders must consider a range of factors when assessing if a prospective borrower can afford mortgage repayments now and in the future. This includes any likely changes in income, spending and the effects of future interest rate rises.
“Lenders should keep their affordability assessments under review to ensure they are lending responsibly.”
A spokesperson for the Treasury told i: “In recent years applicants for new mortgages have been subject to robust affordability testing to account specifically for the risk of rising rates. Affordability tests are determined by lenders in line with FCA.”
“Mortgage arrears remain at historic lows, but if mortgage holders do fall into financial difficulty, FCA guidance requires firms to offer tailored support.”
