In theory low interest rates mean low mortgages, and therefore house prices should be a lot higher than they are.
I recently saw Martin Lewis discussing how people applying for mortgages should “tidy up” their finances first. At the time I believed he was encouraging applicants to “fudge” their income (and expenditure) to get a mortgage. This worried me because I thought he was harking back to the old days of self-certification mortgages for anyone, irrespective of whether they could afford it.
The reality was that he was highlighting that people who were re-mortgaging (where there was no change and no new borrowing) were being excluded from the best deals, and in some cases couldn’t get the borrowing.
How has this come about? Nearly three years ago the FCA introduced stringent affordability checks, with the aim to protect against individuals overcommitting themselves in the event of an interest rate rise. This seems a very sensible move but as with everything there are good and bad sides to this!
The case study – our story
In September 2015 it looked like the UK would increase interest rates; at that time, it seemed sensible to re-mortgage to find the best rate, and lock this in for the next five years to provide protection against future increases.
We are fortunate because the loan (mortgage) we need was 35% of the value of the house (loan to value). We secured a five-year fixed rate deal at 2.39%.
Fast forward a year and we were looking to increase the mortgage to cover some home improvements we wanted to do, the new loan to value would have been 46%. The lender, First Direct, were prepared to offer us 2.08% for five years on the additional borrowing.
Some would argue this was a good deal but 2 year rates were cheaper, and offered greater flexibility. Our view was that everything had changed from September 2015; far from thinking interest rates would rise over the next five years, we were concerned that rates would fall and possibly stay low for the next ten years. Put simply we didn’t want to be locked into a five-year deal.
We explained this to the lender to secure the 2-year deal on the new borrowing. We had worked through the figures and although the saving was minimal it gave us the flexibility we needed. Imagine our surprise when we told we had failed the affordability criteria.
What are the rules
One of the new rules that we came across last year was a thorough analysis of earnings, and all outgoings. This meant explaining every item of expenditure which can seem daunting particularly for those that don’t budget. The aim of this is to ensure you are not hiding anything and can afford what you applying for. This I have no problem with.
But the affordability stress test is something that seems shrouded in secrecy. When I asked the mortgage adviser what this was, he seemed uncertain on the rules and after the discussion I turned to the FCA website:
‘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. This recommendation is intended to be read together with the FCA requirements around considering the effect of future interest rate rises as set out in MCOB 11.6.18(2).
This is a stress test not a forecast for Bank Rate. The FCA has said it will monitor how firms have regard to this recommendation.’
I also discovered this:
The FCA wants lenders to take into account market expectations of base rate movements in the first five years, with lenders’ SVR plus the forward sterling rate as a suggested measure.
I also re-read Martin Lewis’ blogs and it seemed that lenders were arbitrarily setting their own bar which could be as high as a 7% increase in interest rates (this had to be added to their current standard variable rate). For First Direct their lowest 2-year fixed rate is 1.24% but the stress test appears to be 10.69% (although they won’t confirm this).
To put this in context a £200,000 mortgage fixed for 2 years would be £776 per month but the affordability test would push this to £1,916. And here-in lies the problem. For us the increase was £179 per month so not so extreme, but when you are talking about an increase of over £1,000 per month this would be difficult.
Low interest rates = cheap mortgages = time to buy
In theory low interest rates mean low mortgages, and therefore house prices should be a lot higher than they are. But at best they are static in many areas.
We have for some time said house prices were too high and would fall once rates started going up. However, with rates remaining low that puts paid top our theory, doesn’t it?
It seems that the affordability checks are causing problems for people applying for mortgages particularly if they want the lowest rates.
Speaking to lenders, affordability checks are keeping a lid on house price rises, but many people are struggling to get mortgages. There does seem to be some flexibility to work around the rules however:
- It appears that where the mortgage is fixed for less than 5 years the stringent rules apply making it harder to get the lower rates. Whether or not this is the intention of the FCA, this is how some lenders seem to be interpreting the rules
- The longer the term of the mortgage the lower the monthly payments, and the lower the affordability test threshold. Therefore, those wanting a shorter mortgage could be penalised, so opting for the longer term may be a better route (obviously they can just make overpayments and pay down the mortgage quicker)
- A point made by Martin Lewis and others is that if you are saving money into an ISA, Pension or something else on a regular basis some lenders see these as regular payments. This means that when assessing whether you can afford the lower rates, this could exclude you even if you explained you could use it cover the shortfall
There are other examples we could turn to and it is worth adding that the tests are there to avoid a repeat of the mortgage crisis but they are complex, and different lenders apply different rules. This makes it very difficult for those looking for lending to know where to turn and get the best deals. We are not convinced this was the intention of the FCA.
What have we learnt
More stringent checks were needed; forensic tests are great because they test whether someone can afford the mortgage they are applying for. Additionally, what we can afford today, we might not be able to afford tomorrow so there has to be checks on this.
However, there seems to be a disconnect at this point. The FCA appears to have set a bar at 3%, and yet some lenders have set it higher at 7%. If we look back at history, the last time interest rates were at this level was in 1997, nearly 20 years ago. In the environment we are in, is it likely that interest rates will rise to this level in the near future?
This is not the only disconnect; looking further at the FCA rules, lenders have to take into account future spending but it doesn’t say that they have to include payments to savings. This is another barrier that some lenders have added.
It seems strange to be saying this but it appears the FCA are far more pragmatic in their approach. In fact, they have indicated that perhaps the tests should be based on the future direction of interest rates. This is important because it is how the market sees the direction of interest rates over the next five years, and is a more realistic test.
But at the moment we are stuck with different lenders applying their own rules which is good in so far as it keeps a natural lid on the housing market, but it is bad for those looking for mortgages. This makes it that much harder especially where there appears to be little consistency between lenders.
2-year, 5-year or 10-year fixed rate – why there needs to be flexibility
Stepping back to 2015, fixing rates for 5 or 10 years seemed a sensible route because rates would likely be going up over the next few years. The market expectation was that this would settle around the 2% to 3% level.
This has now changed and no-one knows when interest rates will go up next. The Bank of England have indicated that rates could go down (although there is not much further they can move). Wherever they settle it is likely they will remain at this level at least until we leave the EU; this could be a minimum of three years but some argue rates could be at this level for anything between 5 and 10 years.
Depending on someone’s view of risk it may be that in this environment it is about getting the cheapest rate with the greatest flexibility, and that tends to mean looking to the 2-year deals. If rates come down, then in 2-years’ time those deals will be cheaper. Mortgages in the future need to be carefully managed but the problem is that whatever you think or feel, the barriers facing people come from lenders.
The lenders have put their own spin on the FCA rules and no doubt this is because they don’t want to be burnt again. Therefore, people applying for mortgages need to be better prepared so they can hopefully get what they want.
A happy ending
We revisited what we wanted to do and our view was that we felt we need the flexibility that a 2-year rate offered. We knew that as it stood the lender would not move from their decision unless we could prove to them that we understood the risks, and the rules.
It took time but we studied the rules, we applied the stress test and we identified where we could turn if rates went up in terms of free capital. With that information to hand we went back to the lender and put our case to them. Once they saw this they did offer us what we wanted.
We were never looking to bend the rules; even with this extra borrowing the cost is just 18% of our net earnings, to put this in context for first time buyers the average cost is 30% of net earnings (Source: Nationwide). Lenders have to protect themselves and the FCA is right to set guidelines but there has to be a degree of flexibility. For those looking to get a mortgage or re-mortgage, the advice is study the rules, workout your budget and then do the stress tests before you talk to anyone. Doing this means that you are in a much better position to know what you can realistically afford, and ensure that you can outline this to the lender.
Moving forward I take on what Martin Lewis is saying, barriers have to be in place (for certain types of borrowing) but when they stop people getting the best rates even when they can demonstrate they can afford it then something is wrong. I don’t feel this is a problem with the regulator, but more so with the lenders who need to be prepared to adopt a more pragmatic view and sometimes think outside of the box (which thankfully First Direct did).
Note: This is written in a personal capacity and reflects the view of the author. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.