Mortgages.scot

Mortgage Affordability

Today, mortgage affordability is a complex area, many borrowers are frustrated with the often painful, drawn-out process of proving they can afford the mortgage being applied for. To understand why this is, we need to look back in time to see what has changed.

When I first applied for a mortgage way back in 1997 the process was very simple. The lender took both salaries for my wife and I, multiplied it by 4.5 times and that resulted in a figure somewhere around £110,000. So that was the largest mortgage we could take out. Other than a credit search there was nothing else to it. The interest was a killer compared to today, we started off at 8.25%.

It was far from a perfect measure of our ability to afford a mortgage but that was the way it was.

Sub Prime

In 2000 I started working in the Subprime Mortgage Industry. I am sure most are aware of the term Sub Prime. In the UK a subprime mortgage was best described as a ‘light touch’ in relation to understanding affordability. Some described them as ‘trust’ or ‘self-certification’ mortgages. This essentially meant that an applicant could not prove fully prove their income but was comfortable they could afford the payments so lending was agreed on that basis.

The trade-off for lenders was higher rates on interest being charged, as high as 12%, but the reality was that many customers in this space were unable to afford the mortgages being taken out.

Arrears & Repossession

In 2008 at the peak of the financial crisis, there were 4,000 homes being repossessed every month. At that time I was the Head of Arrears & Repossessions for the company I worked for at that time, it was the fastest-growing team in the business, and we are overwhelmed. Mortgage rates were climbing, jobs were lost and much of the Subprime customer base was unable to maintain payments.

At the same time in 2008, around 300,000 homeowners were at least 3 months behind on their payments. At this stage, most lenders would be starting legal action.

Rates plummet

The crisis in 2008 sent interest rates plummeting, by February 2009 it was just 0.5%, other than a period of time at 0.75% the rate has remained very low right up to where we are in May 2020 when it is just 0.1%, the decrease being fuelled by COVID-19.

Low rates helped everyone, even the subprime customers as payments reduced substantially.

The warning signs return

In the years after the 2008 collapse, there were signs of improvement in the market, people were buying, mortgage numbers were rising and there was a lot of positivity out there. But, many including myself seen an issue.

Due to the incredibly low rates on offer, some lenders were giving mortgages at a fixed rate of 1.09%. Great for those that wanted to borrow.

But think about it, for the last 11 years the Bank of England base rate has never been higher than 0.75%, most of that time it has been lower. So anyone who has only ever had a mortgage within that time, numbered in the hundreds of thousands, has never experienced the rates that I had to pay back in 1998 at 8.25%.

Borrowers started over-stretching and borrowing higher amounts of money as a result of the low rates. These were amounts that they could not have afforded if the rates had been higher.

So what if you looked at those mortgages and substantially increased the mortgage rate? The result is that significant numbers of homeowners cannot afford their mortgage payments and many would face repossession. In other words, here we go again!

Mortgage Market Review (MMR)

Regulators were well aware of the pending payment shock effect should rates start to climb again. After much consultation, the Mortgage Market Review came into existence on the 29th of April 2014. I was closely involved in setting this up at my employer and today it is fundamental to mortgage affordability. So what is the aim?

Essentially the main aim is to tighten up lenders' control around proving affordability and ensuring applicants can maintain payments now and in the future. A part of this is to stress-test mortgage payments. So if your new mortgage offers a rate of say 1.5% today, would you be able to afford the repayments if that rate went as high as 6.5%? If the answer to that is no, then the chances are you won’t get a mortgage.

Affordability Stress Test

To recap, the Mortgage Affordability Stress Test exists as mortgage rates are low and have been for around a decade. The purpose of the stress test is to determine whether a borrower could still afford the repayments on a loan should the Bank of England start to increase rates by a certain percentage at any point in the 1st five years of the loan.

Requirements

The regulator that sets the rules and guidance on these matters is the FCA – Financial Conduct Authority. From their publications, it states the following.

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.

OK, so what does that mean? Well, let’s break it down as it can be confusing to understand.

The first element is that we are only concerned with the first five years of the loan. Why? Well, the expectation is that during the first five years there is unlikely to be any significant change to a borrower’s financial circumstances after taking out a mortgage. A broad assumption that will of course not apply to every borrower but it generally does hold true.

Given no significant changes during that time, it stands to reason that if rates were to climb quickly then the only way for a borrower to deal with the payment shock is cut back, change lifestyle and so on in order to meet the higher repayments without a higher income.

The next part is the most confusing for most.

Bank rates were to be 3 percentage points higher than the prevailing rate at origination.

The important part to deal with here is the “prevailing rate at origination”. What does that mean? Probably best with an example.

Assume you apply for a mortgage and the lender offers you a rate of 2% that is fixed for the first two years. The lender must give you an indication of what the rate will be after 2 years assuming you do not try and obtain another fixed rate.

Most often it is simply the mortgage base rate with the lender a mortgage is taken out with. For example, today the Barclays Standard Variable Mortgage rate is 3.59%. This is the prevailing rate at origination. Nobody can say what that rate will be in 2 years when the fixed-rate ends so rely on whatever the rate is today, hence the prevailing rate at origination.

So put that all together. You are borrowing at 2% but in order to meet affordability requirements, the lender will add 3% to the prevailing rate at origination (3.59% + 3%) to give a stress rate of 6.59%.

If you were to borrow £100,000 over 25 years at 2% the payments would be £424 per month. At the stressed rate of 6.59%, they would be £681 per month.

You must, therefore, be able to prove that you can still afford the mortgage based on your income today if the payment were £257 per month higher.

For many, this will mean not being able to borrow the amount they were looking for or it may mean having to increase the term of the mortgage from a more traditional 25 years to an increasingly more common 40 years in order to bring the stressed payments down to an affordable level.

Some may think a 40-year mortgage is far too long but don’t be so hasty, it does not have to mean you can’t shorten it.

Hopefully the first two parts of this guide you understand why and how mortgage payments are stressed. Going to take a look at income next.

Income for affordability

When looking at income for affordability lenders will want to see several items. It is important to note that whilst regulation should ensure all lenders have the same requirements, some will accept types of income that others won’t or may differ in the way they assess a type of income. Some notes below that are fairly standard requirements across all lenders.

For employed applicants:

• Payslips
• P60’s
• Evidence of bonuses received for the last two years
• Bank statements that show salary and bonus being received

The actual evidence required will vary depending on the lender. Some may require one payslip, others three. One or two years P60 and up to six months bank statements to verify salary deposits.

With annual bonuses, these will usually be evidenced by P60’s or an employers letter. Most lenders will also accept bank statements that clearly show the amounts and who paid them into your account.

For more complex items such as carried interest or share awards that vest over time, statements showing their value and vesting dates will be required.

For those relatively new to a role, it may be necessary to produce an employment contract to show any probationary period has ended. Many lenders will allow applications to proceed whilst the probationary period is in progress but not permit drawdown until it completes.

For self-employed applicants:

• SA302 tax statements for the last two years
• Accounts for the last two years
• Letter from an accountant summarising business performance

Lenders tend to treat self-employed applicants in a fairly vanilla way. That is they will expect to see a business making a profit in each of the years assessed, any income being used must be declared in tax returns and tax paid on the amounts.

Some lenders more than others appreciate that business owners do not always draw the maximum amount possible and have retained earnings in the business accounts that can be drawn when required.

Some will also take into account changes in the business or one-off events that meant drawings were lower than usual. Which ones? I can’t give you a list however if you are in the position where you will want a lender to take a view on what has been occurring in your business then do some research first. Many lenders publish their lending standards, from that you can form a view on what they may consider.

The most important factor is to always be up-front. Often I see clients waiting to find out if a lender notices something before making any information available. Remember that anything that does not pass through an automated lending system such as self-employed applicants will result in a manual underwriting process by someone who looks at the account daily so they will spot anything that may cause concern.

Other Income for affordability

For clients that obtain their income from other sources, lenders may still consider an application, but this is where things become more about individual lending policies and they vary wildly. Some other forms of income could be:

Receiving income from a trust

• Using income received from a portfolio of shares
• Some types of benefits can be accepted, child benefits and fostering allowances for example
• If you receive child maintenance many lenders accept this

In the case of benefits or maintenance payments, the lenders will expect it to be paid throughout the term of the mortgage. So with something like a fostering allowance, this is likely to be acceptable if the applicant has no intention of stopping foster care in the future or is not aware of any reason it may stop.

Child maintenance can be more tricky. If you are applying for a 25-year mortgage and your child is 10 years old, then child maintenance is not likely going to be paid until that child is 35. Lenders will insist that the income is reliable and there is no reason to doubt it will continue to be paid throughout the mortgage term.

Again, each lender has its own policies on what they will accept and what evidence is required.

International Income

Most mainstream lenders in the UK require applicants to be residents in the UK for a period of time and earn their income there in order to meet the first qualifying steps to apply for a mortgage. For international clients, it is a bit more difficult in that they will require a lender who has an international offering to support them. There are some lenders who do offer this, however, there are fewer than there used to be.

The issue for lenders in this space is that it requires specialist underwriters to manually process these applications. As a result, you will need to anticipate a more thorough and demanding process. Documents will need to be translated depending on the country of origin, a manual assessment of all bank accounts to determine expenditure and so on.

Referring to the previous section on UK income, ultimately the requirements are the same, however, the evidence may differ.

A key difference that can affect the income that does not originate in GBP is cross-currency haircuts.

For example, someone who earns in Nigerian Naira needs to convert enough of their income to GBP and transfer that to the UK in order to meet the monthly payments on the mortgage.

What if the value of Naira against GBP drops? It could mean the client is unable to service the mortgage as more Naira is needed to be converted each month in order to receive enough GBP to meet the mortgage payment.

To deal with these scenarios lenders apply a cross-currency haircut. This would mean that before anything else is considered they reduce the income by a specific percentage so that if there is a significant change in the exchange rates the client would still be able to afford the mortgage. Some lenders apply a haircut of up to 50% depending on the stability of the currency, so in effect, an applicant will lose 50% of their income before the affordability process really gets underway.

There are specific rules for foreign currency loans

The mortgage lending rules state that;

(1) A firm must warn any consumer with a foreign currency loan, on a regular basis, where the value of either:
(a) the total amount payable by the consumer which remains outstanding; or

(b) the regular instalments; varies by more than 20% from what it would be if the exchange rate between the currency of the regulated mortgage contract and the currency of the EEA State, applicable at the time of the conclusion of the regulated mortgage contract, were applied.

(2) The warning in (1) must inform the consumer of a rise in the total amount payable by the consumer, setting out the right to convert to an alternative currency, where applicable, and the conditions for doing so. It must also explain any other applicable mechanisms for limiting the exchange-rate risk to which the consumer is exposed.

It is the requirements of providing a loan where a different currency than GBP is used to service a mortgage that has led some lenders to stop offering this option. If you have foreign income that needs to be taken into account then it is often best to find a professional mortgage broker who knows where to find lenders that do offer this service. Alternatively, some research of your own should be able to track them down.

Committed Expenditure

It should come as no surprise when assessing a mortgage application that any current commitments an applicant has will be taken into consideration when determining affordability. Committed means anything you have outstanding that must be paid, it is not discretionary in that you could stop paying it if you wanted.

The types of committed expenditure include;

• Other mortgages
• Credit/store card payments
• Car loans
• Council tax
• Child maintenance
• School fees

There are some grey areas, one is private school fees. Some lenders treat this as a commitment whilst others do not. There is an argument that if it came down to it a client could take their child out of a fee-paying school and move into a state school if it meant the difference was being able to afford their mortgage at any point in the future.

It is also important to note that those applicants with second mortgages will also have a stress test applied to them. For example, if you have a holiday home that has a 20-year repayment mortgage at a current rate of 2%, the lender will add at least a further 3% to that, the increased payments must be affordable. Several Lenders require that any interest-only mortgages are affordable as if it was on a repayment basis.

Mortgage regulation states

Examples of committed expenditure are credit commitments such as secured and unsecured loans and credit cards; hire purchase agreements; child maintenance; alimony; and the cost of a repayment strategy where the customer has an interest-only mortgage (where affordability has not been assessed on a capital and interest basis: see MCOB 11.6.48 R (Assessing affordability under an interest-only mortgage).

Essential Expenditure

Previously we looked at committed expenditure, now we need to look at essential expenditure. What’s the difference? Essential expenditure is the minimum amount you need to exist. Food, heat light, clothing, costs associated with children, that kind of thing. Where you have a mortgage on a second home, that is a committed expenditure, however, the costs required to maintain that home in terms of heat and light are part of your essential expenditure.

Lenders have flexibility when it comes to determining essential expenditure. Actual or Modelled.

Actual expenditure

One way is to assess all of your spending. An example of this would be to request all bank statements over the most recent 3/6 months, take out the committed expenditure and average the remainder across the period assessed.

Doing it this way the lender takes everything into account, what you spend on dining out, iTunes, grocery shopping, basically anything you have spent. There is an opportunity to highlight one-off costs that can be removed from the assessment if required.

This method often results in a higher level of essential expenditure due to the inclusion of every single transaction you make.

Modelled expenditure

Assessing the actual spend was quite common however lenders have mostly moved to the modelled method. The Models are usually based on Office of National Statistics (ONS) data. They produce costs based on a minimalistic existence, how much you need to simply exist given the number of adults, children and your current net income.

This results in a lower essential expenditure figure than using the actual expenditure approach as it does not reflect your actual spending. Lenders expect that when you have surplus income you are likely to spend all or at least some of it on items that are not essential to living. But in the event of a change in your income or other life events that mean you have less available, then you will not purchase non-essential items in favour of paying a mortgage and other essential needs.

Mortgage regulation states:

Examples of basic quality-of-living costs (which can be reduced, but only with difficulty) are: clothing; household goods (such as furniture and appliances) and repairs; personal goods (such as toiletries); basic recreation (television, some allowance for basic recreational activities, some non-essential transport); and childcare.

With reference to the way in which essential expenditure is assessed, mortgage regulation also states:

in taking into account the basic essential expenditure and basic quality-of-living costs of a customer’s household, a firm may obtain details of the actual expenditure. Alternatively, it may use statistical data or other modelled data appropriate to the composition of the customer’s household, including the customer, dependent children and other dependents living in the household. If it uses statistical or other modelled data a firm must apply realistic assumptions to determine the level of expenditure of the customer’s household.

Therefore it is far more time-efficient and less resource-heavy to use modelling than have to go through every applicant’s bank statements line by line to understand their spending.

A final point on this, if a lender identifies a future change in circumstances they must factor that into the expenditure. Perhaps a client is in the early stages of pregnancy, although not born yet, the expenditure would need to be increased for a first or subsequent child. If applying for a 25-year mortgage and a child is expected within 9 months then it is clearly going to impact costs for most if not all of those 2 years the mortgage is held.

Credit Score

Lenders always have and always will use credit scoring where they can. They will want to see that you have disclosed all of your committed expenditures and are not in arrears or have defaulted on any accounts. Some may use credit agency scoring to determine whether your application can proceed regardless of what is on it.

Getting through a credit check Credit

scoring has always been a bit controversial although to be fair lenders can be poor at not effectively communicating the reasons for not passing a credit check.

Much of the time it is not because of what is on the report, but in fact what is not on it. Essentially credit agencies provide a score based on the presence or lack of indicators that verify an applicant's existence and past ability to repay credit on time. For example;

Being on the voter’s roll

If an applicant is not on the voter roll and has never had any credit, in effect that person does not exist to the credit agency, then it is unlikely they will score high enough to even get past the initial check and some lenders will instantly decline on that basis. The reason is that it is difficult for lenders to want to trust an applicant with a significant responsibility as a mortgage when there is no trace of them at all.

My parental advice is no longer sound

I have always told my children, that if you can’t afford to pay for it today, you can’t afford it. I am not budging on that advice but I have bent the rules on it and it has helped my oldest son get a mortgage for himself recently. He saved up to buy his 1st car some years ago and could afford to pay it in full. Well, there was some help from the bank of mum and dad.

But rather than pay it all I got the dealer to give him the smallest amount of credit they could, in that case, it was £3,000 over 3 years. No issues with that. The point is that he started building a credit record and proving he could pay back lending.

My other son did the same and recently my daughter got her 1st car and also took out some lending.

The only way to reliably get credit of any kind these days is to already have had some and proven you can pay it back. That helps your score go up and pass the minimum level required to meet lenders' policies.

Checking your own credit record

There are many options out there nowadays to check your score, I highly recommend trying out Clearscore.com, a free service, no credit card required. Just put your details in doing some security checks and they will show you everything you need to know and update you every 30 days. The only thing they do is offer you deals on various financial products, and not that often. No need to pay for this type of regular service.

By keeping track of your credit record you can deal with any issues that may arise that you would otherwise not have been aware of.

The most important element on your way to applying for a mortgage in relation to other lending you have is;

Never be late with a payment, always make sure you have a direct debit set up to take the minimum payment.
Don’t run credit cards up to their limit and only make the minimum payments.
Missed payments and high levels of other lending will certainly have an effect on whether you can obtain a mortgage.

Past credit history

In years gone by there was an expectation that you would have a very clean credit record, however, many lenders are more tolerant of some “blips”. Again it is always down to the individual lender to set their appetite towards lending to those with a less than perfect credit history.

Generally, I have found that they are tolerant of a small number of arrears as long as there are none today and even things like CCJ’s or bankruptcy are tolerated as long as they were at least 3 years ago and there is nothing outstanding still.

If there are current arrears, unsettled defaults, judgements or bankruptcy then it is unlikely any mainstream lenders will consider lending. The only exceptions to this are where there the debt is being disputed and evidence is available to prove that.

Never let a lender discover something first.

An Example

If you have got this far by reading all the other posts in this section then I want to bring affordability to life with a simple example that most will be able to work out themselves with a little research. This example is just a random one, use your own figures.

An applicant is going to borrow on the following basis

Income and spending are broken down as follows

So based on a £150,000 mortgage over 25 years, the applicants have a £30,000 net income, £500 each month in car loans, essential spending of £825 and stressed mortgage payments are £1,013. The result is simply that there is some income left over each month of £162. Therefore, the mortgage is affordable.

Now, in reality, there is in actual fact £539 leftover each month, that is the £162 plus the stressed part of the mortgage payments which is the difference between £1,013 and £636. So the applicants know they have much more available than stated above but the lender is able to prove that should the mortgage rates increase significantly, it will still be affordable with the same net income and costs.

I have simplified the above example purely to illustrate the process lenders will use, however, it will give you a sense of what lenders are going to look at in assessing any mortgage application.

*for essential spending I have used £325 per month for an adult and £175 per month for a child. This is based on data from the Office of National Statistics and makes assumptions that a lender may or may not. It is a reasonable amount assuming the lender used the modelled approach to assessing essential spending.