The mortgage stress test was introduced in 2014 as an extra check when anyone applies for a new mortgage. It required all lenders to assess a borrowers ability to cope with an increase in interest rates.
In this article we explain what the stress test entails, why it was put in place, its benefits for both lenders and borrowers, and how everything changed in 2022.
What is a mortgage stress test?
The purpose of a stress test is to see how well you would be able to afford your mortgage if the Bank of England interest rates went up. It formed part of the lender’s affordability checks.
Although most mortgage applications were for fixed interest rates, where the monthly cost remains the same for a number of years, once these deals ended the repayments could be a lot higher.
So the lenders had to do a calculation, if your deal ended during the first five years of the mortgage, to check your affordability potential.
They would need to look at their reversion rate, once the fixed or tracker deal had ended. This is the default rate that borrowers are switched to if they don’t take up a product transfer or remortgage. Often this is the Standard Variable Rate or SVR.
They take this figure and increase it by 3%.
Default reversion interest rate + 3% = stress test interest rate.
Then they re-calculated the monthly repayments for your mortgage to look at whether you could afford the new payment amount, which would normally be higher.
For example:
A borrower takes out a three year fixed rate mortgage at 2.1% which would then revert to an SVR of 3.5% at the end of the fixed term.
The test checks if they can still afford their repayments if the rate rose to 6.5% (SVR + 3%) within the first five years.
Why was it introduced?
The UK mortgage stress test was a set of guidelines introduced by the Bank of England in 2014.
It was designed to assess the resilience of a borrowers ability to withstand economic shocks, such as a sudden increase in interest rates or a downturn in the housing market.
Under the stress test, lenders were required to assess whether borrowers could still afford their mortgage repayments in the event of a significant economic downturn, such as a recession, which would cause rates to be increased.
The test was put in place to ensure that lenders were lending responsibly and that borrowers were not taking on excessive debt that they would not be able to repay in adverse economic conditions.
The intention is to provide protection not only to the borrower and the lender but also to the financial system and, to a certain degree, the broader property market.
In early 2022 the Bank of England reviewed the methods being used to assess mortgage affordability, including the use of mortgage stress tests. And in July 2022 it decided to withdraw its mortgage stress test recommendation, with effect from August 2022.
Why was the stress test removed?
The stricter affordability test was part of a response to years of reckless mortgage lending practices, such as offering 100%+ mortgages and granting self-certified mortgages without verifying income.
Such practices were thought to have played a role in the 2008 financial crisis.
The Bank’s review and consultation in 2022 concluded that the mortgage stress test had only led to a small number of mortgage refusals. Furthermore, it found that alternative methods for evaluating mortgage affordability were more useful, with a greater degree of accuracy.
What affordability checks are still in place?
The FCA’s Mortgage Conduct of Business responsible lending rules require lenders to take a wide assessment of affordability.
So while the specific need for an interest rate stress test has been removed, lenders are still obligated to ensure borrowers can afford the repayments now and in the future.
One such test is called a debt to income ratio calculation. It basically works out how much of your gross income is being used to repay debt.
There are some lenders that still use a version of the stress test as part of their underwriting processes.
There is another high level technical check known as the Loan to Income flow limit.
This basically limits the number of mortgages that each lender can approve above 4.5 times the borrowers income. This restricts the amount of lending that is based on stretched income multiples.
Product transfers
Interestingly, mortgage product transfers and remortgaging with the same lender, do not undergo stress test checks.
As you remain with the same lender, and providing you have kept up the repayments, there is no requirement for you to show proof of your current income or for your credit file to be checked.
Buy to let lending
Buy to let (BTL) mortgages are treated differently to residential mortgages, and the amount that you can borrow for a buy to let mortgage will depend on the rental income that the property is expected to generate.
Since 2017, the Prudential Regulatory Authority (PRA) has introduced stricter criteria for BTL borrowers, including a required “buffer” in rental income of either 125% or 145%. This income cover ratio (ICR) is designed to ensure that borrowers have enough surplus income from the property to cover expenses such as repairs, non-payment of rent, and service charges.
Lenders also apply a stress test to BTL mortgage applications, factoring in the borrower’s ability to pay a higher rate, even if the actual mortgage rate is lower. This stress income cover ratio (SICR) is applied in case interest rates do rise to that level, ensuring that landlord can continue to make mortgage payments even if rates increase.
Overall, BTL mortgages are subject to stricter affordability checks and criteria, including higher interest rates and stress tests, ensuring that borrowers are better prepared to deal with any future financial challenges.
Portfolios
Those landlords that own four or more investment properties will see themselves categorised by lenders as a ‘portfolio landlord‘. New lenders will still apply a stress test but they will also want to see all of the information regarding the let properties you own.
Investors with many properties may find that a buy to let portfolio mortgage is worth considering. This simplifies your finances by providing one mortgage that funds multiple properties.
Does this mean you can now borrow more?
Eliminating this test could enable borrowers to secure larger loans, potentially benefiting those who are facing difficulties in entering the housing market.
However, it is important to remember that lenders are still bound by other FCA regulations, which start with the income multiples used to calculate the maximum loan. From there the overall mortgage affordability must be met in order for a mortgage offer to be issued.
You should always make an honest judgement on your own ability to meet higher monthly payments. The mortgage is by far the highest outgoing that most people pay, and it provides your home and a roof over your head.
Being unable to afford the payments could lead to mortgage arrears, then a default and finally repossession.
Should you find yourself in financial difficulty it is important to seek advice, either from your broker or a debt charity, and let your lender know what the problem is.
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