Lenders routinely assess whether a new borrower will be able to afford to repay their mortgage. The Financial Conduct Authority’s (FCA’s) responsible lending requirements specify that these affordability assessments take into account a borrower’s income, expenditures and their mortgage payments.
The size of a typical monthly mortgage payment depends upon the loan size, the length of time the loan is paid over, and the interest rate on the loan.
Lenders assess not only whether a borrower will be able to afford their mortgage now, but also whether they will be able to afford it in the future. Lenders use ‘stress-tested’ interest rates that are above expected mortgage rates, as they add in a buffer if interest rates were to increase by more than expected. Current and expected interest rates have risen since 2021, which has increased stress-tested interest rates.
One way of looking at whether borrowers can afford their mortgage is by dividing their stressed mortgage repayments by their incomes to calculate a stressed debt service ratio. UK lenders will typically lend at stressed debt service ratios of up to around 40%.
Assuming lenders do not allow borrowers’ stressed mortgage repayments to take up much more than 40% of their income, higher stress-tested interest rates mean that borrowers have to either reduce the amount they borrow relative to their income or increase their mortgage term.
Chart A: Monthly average of stress-tested interest rates and loan to income ratios on a sample of new UK mortgages (a)
The chart above demonstrates how average loan to income (LTI) ratios have fallen as stress-tested interest rates have risen since 2021, using a sample of new mortgage completions with stressed debt service ratios of 37.5% to 42.5% and mortgage terms of 25–30 years.
Between 2015 and 2021, prospective borrowers were assessed at stress-tested interest rates averaging around 7%. Now borrowers are assessed at stress-tested interest rates of over 8%. For this sample of mortgage completions, this has contributed to a fall in the monthly average LTI from around 4.7 to 4.3.
Consequently, aggregate new mortgage lending has fallen and the share of new overall mortgage lending at higher LTI ratios has fallen. The average LTI of new mortgages has fallen from around 3.4 in 2021 to 3.2 in 2023 Q1 and the share of new mortgages at an LTI greater than or equal to 4.5 has fallen from 9.6% in 2021 to 6.0% in 2023 Q1.
Another way mortgagors could mitigate the effect of higher stress-tested interest rates on the amount they can borrow relative to their income is to extend their mortgage term. Increasing the mortgage term allows mortgagors to repay their loans over a longer period, lowering their monthly mortgage repayment and hence their stressed debt service ratio.
There is evidence that many households are taking this approach. For example, the share of new lending with mortgage terms greater than 35 years has increased from 5% in 2021 to 11% in 2023 Q1.
If interest rates remain high, new borrowers are likely to continue to lower their loan size relative to income and extend their mortgage term.
This post was prepared with the help of Gerry Gunner and Marek Rojicek.
This analysis was presented to the Financial Policy Committee in 2023 Q2.
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