Why has ‘affordability’ suddenly become one of the main topics of debate in the mortgage market?
There are a number of factors which are driving renewed interest in this topic.
First, house prices have consistently risen above the rate of inflation over the past few years and the average house price in the UK is now just over £130,000. Mortgages are, therefore, by far the largest financial commitment most people will make in their lifetime.
Second, interest rates are at record low levels and mortgages are very cheap. Borrowers are therefore willing to extend their borrowing to be able to purchase property, which is still seen as a good investment (hence the boom in buy-to-let mortgages). Homeowners are also taking advantage of low interest rates by remortgaging to raise capital for everything from home improvements to buying cars and consolidating debt.
Rising house prices, low interest rates and a boom in consumer borrowing, have led the Financial Services Authority (FSA) to call for lenders to carry out a ‘sanity check’ on information supplied by borrowers to ensure they can afford the loans for which they are applying. It has warned the mortgage industry that if people continue to borrow at such levels there could be ‘unpleasant consequences further down the line.’
This leads on to the third factor: the spectre of rising interest rates. Most commentators are predicting an increase in interest rates during the next year and some borrowers may find higher mortgage payments difficult to repay.
The fourth and final factor is the continued popularity of self-certification mortgages. The FSA, in its Consultation Paper 186, has said that it believes self-cert loans are not suitable for employed applicants and has asked for recommendations about how self-cert loans should be handled in future.
Surely lenders have had to assess affordability for years. They must have developed techniques which enable them to accurately predict an applicant’s ability to repay a mortgage?
True, but underwriting techniques are by no means infallible. Some lenders will individually underwrite each mortgage application and borrowers have to declare their income and outgoings – and provide documentary evidence. Although this may sound like a watertight approach to assessing affordability, it does have drawbacks, both in terms of assessing income and expenditure.
Income can be difficult to assess because some borrowers do not have a regular monthly income. This is particularly true of the the self-employed who also want to keep salaries low to minimise their tax liability and who compensate by boosting their income via dividend payments. Suppressing income in this way is tax efficient but can make getting a mortgage more difficult, which is precisely why self-certification mortgages have become so popular. Even employed people can have multiple income streams from several jobs and returns from investments and this also makes self-certification mortgages attractive to them.
Expenditure can be difficult to assess because it is hard to know if all expenditure has been declared. Lenders will ask for details of obvious financial commitments, such as loans and credit card payments, but it is virtually impossible to capture all financial outgoings.
How do lenders overcome this problem?
An underwriting technique which is used by many ‘mainstream’ lenders is credit scoring. Credit scoring uses statistical techniques to assess the likely performance of a loan, by using historical data to predict an applicant’s potential to repay their mortgage in the future. Lenders will analyse their existing loan books to identify factors which may be significant when differentiating between good and bad borrowers.
For example, borrowers who are married and in full time professional employment will probably get a higher credit score than borrowers who are single and in part-time manual jobs. Each significant factor is given a score and if borrowers reach a threshold score, they will be granted a mortgage.
Credit scoring does work and has proven its ability to reduce arrears, but it is also not an infallible underwriting technique. It is based on statistical probability and as such is not based on a full assessment of an individuals detailed financial circumstances.
What other solutions exist?
One approach being tested at the moment is the use of an ‘affordability declaration’ in conjunction with self-certification mortgages. When self-certification mortgages were first introduced many people predicted a significant rise in arrears and repossessions, but this has not happened and many self-certification loan books are performing extremely well.
The reason for this is obvious: borrowers are best placed to really understand their true income and the same applies to their outgoings.
To assess if a borrower can afford a larger mortgage, what they need to know is how much their mortgage payments could go up by in the future if mortgage rates do rise – they then have the ability to assess their own affordability, based on the knowledge of what they really have in their bank account each month.
This is precisely what an affordability declaration does. It gives borrowers that vital information and then asks them to consider (and declare in writing) that they have fully considered the potential impact of rising interest rates. It is an important ‘reality check’ for borrowers before they sign on the dotted line.
The affordability declaration may not be the perfect solution to assessing affordability (if such a thing exists), but it could be an important step forward.