Whether you believe the 2008 financial crisis was caused by the US sub-prime market, or whether it was merely a trigger for the credit crisis, it is undeniable that, in the US at least, too many mortgages were sold to people who simply could not afford them.  Financial regulators around the world believed that banks, knowingly or not, had allowed unacceptable risks to be taken in the mortgage market.  In 2010, the Financial Services Authority (FSA), the then regulator of financial services in the UK, published the Mortgage Market Review: Responsible Lending (MMR) which put forward strict proposals that would limit lending and decrease the likelihood of mortgage holders being overburdened with unstainable debts. The reason for this is stated by the FSA in the MMR as being because “the existing regulatory framework had been ineffective in constraining particularly risky lending and unaffordable borrowing. Circumstances led lenders to feel insulated from losses arising from poor lending, largely as a result of being able to pass risks onto others[1]”.

Traditionally, lenders determined the amount a borrower could afford to borrow solely from the borrower’s annual income, specifically a multiple of the borrower’s income, known as the loan-to-income ratio.  The loan-to-income ratio was usually three to five times the borrower’s annual income.  For example, if a borrower had an annual income of £100k, the lender would could lend to them between £300k to £500k.[2]

Since the publication of the MMR in 2010, the regulator of financial services in the UK has been split up from the FSA to the Financial Conduct Authority (FCA) and the Prudential Regulatory Authority (PRA).

Between 2014 and 2016, the changes outlined in the MMR and the implementation of the Mortgage Credit Directive 2015 (MCD 2015) resulted in significant changes to the regulatory requirements on lenders.

Residential mortgage contracts

The FCA requires mortgage lenders to assess the affordability of a “regulated mortgage contract” for a borrower who is an individual. A regulated mortgage contract is where at least 40% of that land is used, or is intended to be used, as or in connection with a dwelling. This applies to mortgages where a loan made to an individual is to enable the individual to buy a home for themselves where the loan is secured on that home. However, it can apply to mixed use properties as well provided that the occupier uses at least 40% of the total of the land as or in connection with a dwelling. For example, if the property in question has a shop and a flat, and the flat is more than 40% of the property, than it may come under the regulatory framework of the FCA.

Regulated mortgages come under the FCA requirements in the Mortgages and Home Finance: Conduct of Business Sourcebook (MCOB), whereby lenders must not enter into the transaction unless they can demonstrate that the mortgage contract is affordable for the individual borrower[3].  This will be of no great surprise; of course, a lender should not enter into a transaction with someone who cannot afford it. However, what is affordable for a residential borrower has changed dramatically as a result of the MMR.

As of 2014 in the UK, lenders of regulated mortgages must prove a borrower can afford the monthly repayments by scrutinising every aspect of their income and expenditure, including future changes to both.  The bank cannot simply apply a multiple of the borrower’s income. It is no longer enough to determine only what a borrower can afford based on their present circumstances; a mortgage lender must show that a residential borrower can afford the transaction in the future. As such, lenders of regulated mortgages are required to assess the future changes to income when assessing affordability.

The “Interest Rate Stress Test”

The most controversial aspect of the new affordability assessment involves applying what the FCA and PRA call an “interest rate stress test“[4] on the borrower of regulated mortgages.  The point is to test whether a borrower could still pay the sums due if interest rates were to rise at any point over the first five years of the mortgage contract.

The minimum level of interest rate rise that the lender should apply in its assessment of affordability has been of some debate.  the FCA states that in coming to a view as to likely future interest rates, a mortgage lender must have regard to market expectations and any prevailing Financial Policy Committee (FPC) recommendation.

The FPC was established by the Bank of England in 2013 as part of the new system of regulation brought in to improve financial stability after the financial crisis.  It comprises of six Bank of England staff: The Chief Executive of the FCA, one non-voting member of HM Treasury and five external members chosen for their experience and expertise.

In the June 2014 the FPC recommended that:

When assessing affordability, mortgage lenders should apply an interest rate stress test that assesses whether borrowers could still afford their mortgages if, at any point over the first five years of the loan, Bank Rate were to be 3 percentage points higher than the prevailing rate at origination. (emphasis added)

Therefore, from June 2014 onward, lenders had to apply the interest rate stress test based on whether the “Bank Rate were to be 3 percentage points higher than the prevailing rate at origination”.

As with many aspects in the sprawling framework of financial services regulation, lenders were able to interpret the wording of the 2014 FCP recommendation in varying ways.  The phrase “Bank Rate were to be 3 percentage points higher than the prevailing rate at origination” did not specify what bank rate should be referenced at origination.  Was it the reversion rate in the mortgage contract, the initial product rate, or the lender’s standard variable rate?  As a result, there was significant variation among lenders on the stressed interest rate used to assess affordability.  Such uncertainty created the risk that lenders would adopt an inconsistent approach or try to apply a looser standard when testing affordability.

Based on these concerns, the FCP changed their recommendation in June 2017 to the following:

mortgage lenders should apply an interest rate stress test that assesses whether borrowers could still afford their mortgages if, at any point over the first five years of the loan, their mortgage rate were to be 3 percentage points higher than the reversion rate specified in the mortgage contract at the time of origination (or, if the mortgage contract does not specify a reversion rate, 3 percentage points higher than the product rate at origination). (emphasis added)[5]

The June 2017 FCP recommendation makes it absolutely clear that lenders must base the interest rate stress test on a 3 % increase in the lender’s reversion rate.  If the regulated mortgage contract does not specify a reversion rate, the stress test must be 3% higher than the product rate at origination.  For example, if a borrower is offered a fixed rate for the first two years of the mortgage loan at 2% but this is reverted to the bank’s standard variable rate of 4% after the two years, then the borrower must be able to afford the loan repayments at 7%.

Residential buy to let mortgage contracts

The affordability requirements stated thus far apply to those buy to let mortgages regulated by the FCA when the property is either partly occupied by the borrower or let to an immediate family member.

Mortgages known as “consumer buy to let mortgages” are also regulated by the FCA under the MCD Order 2015. Consumer buy-to-let mortgages are regulated as residential mortgages, aimed at “accidental landlords” and non-professional landlords. They offer protection to people renting out their homes, but not as a business or investment. The interest rate stress test does not apply to in these circumstances.

Most buy to let mortgages are undertaken on a commercial basis.  Buy to let mortgages on residential properties where the owner or related person does not occupy the property are outside the scope of the FCA regulation. In these circumstances the PRA have given buy to let lenders minimum standards to reach. The PRA in September 2016[6] outlined these minimum standards for firms providing buy to let mortgages outside the scope of the FCA.

When assessing the affordability of a buy-to-let mortgage contract, the PRA expects firms to use a method which will include:

• whether the income derived from the property is enough to support the monthly interest cost of the mortgage payments using an interest coverage ratio (ICR) test; and/or
• if Lenders are taking account of personal income as a means for the borrower to support the interest and capital (if applicable) monthly mortgage payments, whether that income, in addition to any income derived from the property.

When assessing affordability in respect of a potential borrower, the PRA emphasises that lenders should take account of likely future interest rate increases on affordability. The stress test proposed by the PRA is 2% above buy-to-let mortgage rate or a minimum of 5.5%, whichever is higher.

Commercial L

Mortgage prisoners

Now, what of the mortgage prisoners stuck on high rates of interest unable to switch to a new lender because they fail the new affordability test?  Fortunately, this situation has been rectified by the FCA and PRA and mortgage lenders can choose to carry out a modified affordability assessment where a consumer has a current mortgage, is up-to-date with their mortgage payments (and has been for the last 12 months), does not want to borrow more, other than to finance any relevant product, arrangement or intermediary fee for that mortgage, and is looking to switch to a new mortgage deal on their current property.

[1] Financial Services Authority; Mortgage Market Review: Responsible Lending; CP 10/16 chap1

[2] As of 2017, the number of mortgages a lender can issue at more than four and half times an individual’s income is capped at 15% of their total number of mortgages.

[3] MCOB 11.6.2R(1)(b)

[4] https://www.fca.org.uk/firms/interest-rate-stress-test

[5] At its meeting in September 2017, the FPC confirmed that the affordability Recommendation did not apply to any remortgaging where there is no increase in the amount of borrowing, whether done by the same or a different lender

[6] Supervisory Statement | SS13/16 Underwriting standards for buy to-let mortgage contracts