Mortgage Stress Tests Have Now Been Scrapped But What Does This Mean?
Mortgage stress tests have been used in mortgage lending for several years but have now been officially scrapped. Let’s have a look at what this will mean for mortgages and the property market.
What is a Mortgage Stress Test?
A mortgage stress test is a test used as part of a mortgage application. A mortgage stress test is used to find out if the borrower will still be able to afford the repayments if mortgage interest rates rise.
A mortgage stress test is an affordability check. It is a way of predicting future affordability.
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How does a Mortgage Stress Test Work?
Mortgage stress tests work by calculating what the repayments on a mortgage will be if the mortgage interest rate rises, as well as what they will be now. The lender then decides if the borrower will still be able to afford the higher repayments at the higher interest rate, bearing in mind their income, outgoings and other circumstances.
Assume, for example, that the mortgage interest rate is 3% and the borrower’s monthly repayments on their mortgage will therefore be £1,200. Now assume that the mortgage interest rate rises to 6% which makes the borrower’s monthly repayments £1,600. The lender will decide whether that higher monthly repayment is affordable or not when considering the mortgage application.
If the borrower fails the mortgage stress test they may only be offered a smaller mortgage advance or their mortgage application may be rejected completely.
Stress Tests and Buy-to-Let Mortgages
Mortgage stress tests are used both in residential mortgage lending and in buy to let mortgage lending. They also aim to ensure that a buy to let mortgage is affordable should interest rates rise. Buy-to-let mortgages may be stress tested at a rate of +5%.
Buy-to-let mortgages may also use a stress test known as a stress income cover ratio or SICR. This is used to ensure that the rental income on a property will exceed the mortgage repayments by a certain amount, typically between 125% and 155%.
The Reasons for Stress Tests
- They are intended to offer protection to both the borrower, the lender and the financial system and to some extent the wider property market.
- They protect the borrower from taking a mortgage which could become unaffordable, from facing financial difficulties and from potentially having their home repossessed.
- They protect the lender from advancing mortgages which may fall into arrears and default.
- They protect the financial system from a situation where many borrowers may default on their repayments and so lenders may face liquidity issues or potentially ‘run out of money’.
- They protect the property market from a situation where it may be flooded with forced sales of distressed or repossessed property which could push property prices down.
Who Introduced Them?
In the late 2000s, the Financial Services Authority (FSA) conducted a Mortgage Market Review which resulted in an overhaul of the responsible lending requirements for mortgages.
The Mortgage Market Review came about after what was considered to be many years of imprudent mortgage lending practices. These included 100%+ mortgages and so-called self-certified mortgages which were granted without proof of income. It was believed that such practices contributed to the 2008 financial crisis.
In the UK the Bank of England recommends to mortgage lenders like banks and building societies what criteria they should use when extending credit.
The Financial Policy Committee (FPC) of the Bank of England recommended that mortgage lenders such as banks and building societies introduce mortgage stress tests in 2014. This was during a period when it was believed interest rates could rise quickly after a period of record low rates. This recommendation applied to all lenders who extended residential mortgage lending over £100 million annually.
The Bank of England’s Stability Report subsequently recommended that the mortgage stress test rate be set at 3%. This meant that lenders had to ensure a borrower’s mortgage repayments would still be affordable if interest rates rose by 3% above their standard variable rate (SVR) within the next five years.
For example, a borrower taking out a three-year fixed rate mortgage at 2% which would then revert to an SVR of 4% at the end of the fixed term would still need to be able to afford their repayments if the SVR rose to 7% within five years.
Mortgage Stress Tests Scrapped
In early 2022 the Bank of England conducted a review and consultation into the methods used to assess mortgage affordability, including the use of mortgage stress tests.
Subsequently, in July 2022 the Financial Policy Committee of the Bank of England decided to withdraw its mortgage stress test recommendation. This took effect from 1 August 2022.
The grounds for scrapping mortgage stress tests were that, with rising property prices, greater numbers of people were likely to be refused a mortgage on the basis of a stress test alone. It was felt, however, that this could result in mortgage applications being refused to those who could actually afford the repayments, including those who were already paying more in rent than their mortgage repayment would be.
The review and consultation also found that relatively small numbers of people had been refused mortgages as a result of the mortgage stress test in any case. It also considered that other methods of assessing mortgage affordability were more accurate.
What could Scrapping Mortgage Stress Tests Mean?
In simple terms the scrapping of mortgage stress tests means that mortgage stress tests do not have to be used by lenders when considering mortgage applications.
It means that affordability does not need to be considered using a mortgage stress test.
It means that the impact of rising interest rates does not need to be assessed via a mortgage stress test.
The scrapping of mortgage stress tests could mean that some borrowers who would have been rejected for a mortgage may now be able to qualify for a mortgage. It could mean that some mortgage applicants may be able to get a larger mortgage than when stress tests were used.
The scrapping of mortgage stress tests will apply not just to new mortgages but to those remortgaging. So it could be easier for some borrowers to remortgage.
Some borrowers could potentially be at risk of financially overstretching themselves with the scrapping of mortgage stress tests, however.
The removal of stress testing could help maintain or even increase demand in the property market. It could help support or increase property prices, as homebuyers may be able to afford to pay more for a property.
It is important to realise, however, that the scrapping of mortgage stress tests will not lead to unrestrained mortgage lending.
Lenders can and will still apply other tests and rules when assessing mortgage affordability. They will still consider an applicant’s income and other outgoings. They will still use other guidelines, such as a maximum loan to income (LTI) ratio of 4.5, or a maximum loan to value (LTV) amount. The Financial Conduct Authority’s (FCA) Mortgage Conduct of Business (MCOB) rules will still require lenders to lend responsibly. The FCA requires lenders to use a mortgage stress test of 1%.
It is possible, therefore, that the scrapping of mortgage stress tests will not mean very much for the mortgage market and the property market.
What the Experts Think
This report quotes a mortgage broker who believes the removal of mortgage stress tests will be good for first-time buyers, who will now be able to borrow more.
This report quotes an expert who believes the scrapping of mortgage stress tests will ‘not open the floodgates’, as lenders will still stress test to insure against rising interest rates.
This report quotes an expert who suggests the scrapping of mortgage stress tests will not make much difference, as the principles of responsible lending and general affordability remain in place and unchanged.
This estate agent believes that borrowing to buy property could become easier for many with the Bank of England’s move to remove mortgage stress tests.