Will the bubble ever burst? Are borrowers about to get their fingers burnt again? And have lenders really learnt their lesson from the last housing market crash? Countless articles have sought to answer these questions in one way or another over the last few months, and while some sections of the media have been predicting a crash for a while, the market is showing little sign of wavering. While there is no smoke without fire, and affordability is clearly being stretched in areas of rapid growth, there are claims that the economic situation is different now and we are unlikely to revisit problems brought about by affordability.
Compared to last year house prices have increased by an average of 20.8%. The average house price is now £111,823, according to Halifax. While these figures will vary by region, town and even street, some areas, especially in the south east, are now proving to be well beyond the means of most borrowers. But with no sign of a hike in interest rates, the market is being pushed ever upwards. And so it follows that, logically, many borrowers must be finding that they can get finance for deals that they could not have got a few years ago, because salary increases have in no way matched those of house prices.
The ‘affordability gap’ is undoubtedly becoming more of an issue as many borrowers are forced to stretch themselves financially in a bid to get a foot on the housing ladder.
A widening gulf
The affordability gap is the term given to the gulf between rising property rises and the level of mortgage repayments that borrowers can afford. According to the Royal Institute of Chartered Surveyors (RICS) average house prices are expected to rise at around 18% this year, compared with average earnings growth of around 2%. It doesn’t take a mathematician to work out that standard income multiples are no longer enough to keep pace with this growth and consequently many lenders are revising them upwards. Worryingly this sounds remarkably similar to the situation a decade ago when borrowers took on a lot of debt in the rush to get on the property ladder, and then got into repayment difficulties when interest rates rocketed to 15%.
While lenders have been accused by some of fuelling this rapid increase in prices by relaxing their lending criteria, is this necessarily a problem if interest rates stay within a narrow band close to their current position?
David Connolly, business development manager at Mortgage Express, believes it is not a problem because the economy has changed. ‘Interest rates are at their lowest level for forty years, and it is viable to suggest that they will stay fairly low from now on, although it would be naÃ¯ve to imagine that they will never move. I would hope the economy has moved on from the last crash, and lenders have learnt a lot of lessons from the early 1990s.’
The worry of borrowers and lenders alike is that prices will peak and slump as they have done in the past. If the economy is now operating differently the slump may never happen, but it can’t be ruled out. Earlier this year the Council of Mortgage Lenders (CML) took the unprecedented step of urging the Bank of England to raise interest rates slightly, and slow down house price growth before affordability becomes a more serious issue in the future. In effect it could have been seen as a call to the Bank of England to save the lenders from themselves. David Hollingworth, mortgage specialist at Bath based mortgage brokerage London & Country, believes it was right to remain cautious: ‘There is a danger that borrowers could be overstretched if interest rates shoot up. I don’t think we will see rises as high as 15%, which happened last time. Even if the headline rate does go up by 1-2%, most loans should still be affordable. But who knows, with the problems in the Gulf interest rates could go up and then we would really find out if the economy has moved on.’
However, many lenders believe the economy has changed fundamentally in the last decade and as such are prepared to revise their lending criteria. Essentially, there are two types of lending criteria, income multiples and affordability tests. Older, more traditional lenders tend to use income multiples, but many of the new banks are moving towards affordability tests on top of, or instead of, income multiples.
Hollingworth says: ‘Most lenders are doing higher income multiples than they were three years ago ‘ even the smaller mutuals. Clearly borrowers are demanding more money as house prices keep on increasing. A couple of years ago three times income was common, now 3.25, 3.5 and even 4 times income is relatively common. However, I think it would be fair to say lenders are extremely wary of being too ‘gung ho’ and finding themselves in a fix again if the economic climate does change.’
There is an argument that if three times income was acceptable in the past, it should be more now and maybe five times income multiples at today’s levels is not a problem for many people.
Nigel Gardner, operations director at Genesis Home Loans, says: ‘The argument for higher income multiples has some merit; interest rates are lower and more stable. It would appear reasonable to allow five times income at 5%, when in the late 80s three times income at 15% was allowed. I still feel a mortgage is a long-term commitment, and although long-term predictions mean interest rates should stay reasonably low, it would not be unfeasible to see it going up by 2, 3 or even 4% in the future.’
Competition is clearly a factor behind the changes, and lenders are looking at increasing their criteria because of greater competition in the market.
One of the explanations behind the growth of self-certification lending is that income multiples are still not high enough for some borrowers ‘ especially if they are seeking to minimise their ‘paper’ income for tax purposes. But if more borrowers choose to self-certify their income they could be leaving themselves open to problems over affordability in the future.
Ray Boulger, senior technical manager at Charcol, says: ‘More and more people are self-certifying their income and pushing their mortgage limits, especially in London. Income can be defined in many different ways, and if someone gets paid a lot in overtime conventional lenders may not accept it. Going non-status gives borrowers more scope, although it is more expensive.
Lenders that base their lending criteria on affordability often offer more than four times salary. The people who fare well in affordability tests are those with low levels of debt and other commitments, but they may not have been eligible for much beyond the standard income multiples if that was what the lending decision was based on.
Hollingworth says: ‘Lenders can offer higher multiples in effect by looking at overall affordability. Some lenders are still treating affordability as a side issue, but many are now using it in certain circumstances. More and more are using affordability as a measure. The big names are now using it, and it is fair to say that it will become more popular in the future.’
Commenting on its lending practices, Peter Mounty, head of communications at Cheltenham & Gloucester, says: ‘The focus of our underwriting tends to be on affordability. If they have a share portfolio, a trust fund and a smallish income, it would mean they have the wherewithal to repay the debt. We may offer big loans in these circumstances, but in the accepted sense of interest multiples we would not offer more than our standard multiples.’
The other major issue surrounding affordability is the increase in 100% and 100% plus mortgages. With house price increases outstripping earnings they are likely to become more prevalent as potential borrowers cannot build up the equity quick enough to save up for a deposit. Gordon Jolly, managing director of Amber Homeloans, says: ‘100% plus loans are a different risk to normal mortgages, as the borrower has no equity stake in the property. Increasing property values mean that it is probably not going to be a problem, but if they buy when property values are at their peak and then they drop they may run the risk of getting into negative equity unless they have put some savings aside.’
Gardner says: ‘I do not hold with 100% or 100% plus mortgages. Three years down the line if the market slows down or even reverses and there are case of negative equity, the borrowers won’t thank the lenders. I think lenders have a short-term memory.’
Boulger agrees: ‘Clearly the less you need the better, but if the choice is between getting on the ladder and getting 100%, or not getting on at all then so be it. We will see more loans taken out on this basis as the number of university graduates with debts going into five figures is set to increase in the next few years. The choice for them is to pay the debt and then get a mortgage or to transfer the debts onto a new deal and take out a 100% plus mortgage as it may work out cheaper.’
So while house prices are rising at their present rate, the affordability gap will keep on increasing. No-one can predict the future and how interest rates will react to the wider economy, but it seems as if lenders are still conscious of the last crash and are remaining wary. In this climate, the best thing brokers can do is to check that mortgage repayments are affordable to clients and would still be affordable if the interest rate was 2% or even 3% higher.
Affordability problems are rising as house prices outstrip growth in income.
Income multiples have been relaxed. Clients must be able to afford interest rate hike of 1-2%.
Lenders that use affordability tests may offer higher loans if the client can service the debt.