19 Jan 2017
Author: Stephen Breen
The credit crisis saw mortgage deals for those with a small deposit vanish – but confidence has slowly returned to the market and 95% mortgage deals are aplenty. However, first time buyers with less than 15% to put down may still find themselves struggling to obtain finance, thanks to stricter affordability checks and stress testing.
Banks and building societies are required to conduct stress testing which evaluates the borrower’s ability to make the repayments if the interest rates were to rise substantially higher than the initial rate on offer.
Property data company Hometrack reports that while 52% of first time buyers renting a 2-bed home will pay more to their landlord than they would for a mortgage at 90% loan-to-value, only 2% would pass a lender’s stress test. Hometrack’s research director Richard Donnell believes that stress testing at such a high rate is making it difficult for creditworthy borrowers to purchase a property with anything less than a 15% deposit.
The stress test
The test requires that lenders consider whether the borrower could afford their mortgage repayments if the interest rate increased by 3% over the first five years of the loan. This requirement, laid down by the Bank of England’s Financial Policy Committee (FPC), was designed to stop borrowers taking on high levels of debt that they may struggle to repay if the financial climate should change.
Many lenders have interpreted the requirement to mean that borrowers should have enough income to cover interest charged at 3% over the lender’s Standard Variable Rate (SVR). SVRs are typically around 4 – 4.4%, so borrowers would need to be able to afford interest rates of around 7%.
As an example, for borrowers with a 5% deposit, a mortgage on a £250,000 property would be £237,500. If the borrower took a 3 year fixed deal at 2.69%, the payment would be £1,088. Instead of testing the borrower’s ability to afford this, or to afford the SVR which they would revert to after the fixed deal, the lender will assess their ability to repay at 7% – £1,679 a month, or £591 more than their actual payment. This would lead to many first time buyers being rejected for the loan (Source: The Times).
All lenders must perform the stress test but the exact calculations that each lender uses are kept secret, to avoid any attempt to manipulate them.
How to pass the stress test
There are a number of ‘tricks’ that can help first time buyers with a small deposit to past the stress test.
The most obvious trick is to reduce the amount borrowed, but most will not be in a position to do this.
Choosing your lender carefully can help – although the exact stress tests are not made public, experts say that regional building societies tend to be more flexible, assessing applications manually and taking a common sense approach.
Taking a mortgage for an initial term of five years or above can also be helpful. Lenders only need to assess how an interest rate rise would impact the first five years of the loan, so lenders offering these products may use a lower stress test.
Applying for the mortgage with another person who will not be named on the deeds (joint application/sole proprietor) may be a solution. The added person’s finances can then be used as part of the affordability and stress testing. Because they are not named on the deeds, the second home stamp duty hike (an increase of 3% over standard rates) does not apply – and there is no capital gains duty when the property is sold. However, this person will be liable for the full cost of the mortgage (unlike a guarantor, who in the event of a default would only be liable for the shortfall). Metro Bank, the Woolwich, Furness Building Society and Hinckley & Rugby Building Society offer this type of loan arrangement.
Another option is to increase the mortgage term – this lowers the monthly repayments. With lenders increasing their maximum lending age in recent years, this option is not just for first time buyers. Check carefully whether you can overpay each month to avoid the interest implications of paying over a longer term.
Finally, reducing your expenditure in the run up to your mortgage application can help you pass the stress tests. Do a review of your spending and see if you can cut your utility bills by switching providers. Consider reducing TV and phone packages to a minimum, and keep your household expenditure (food, toiletries etc) under control. You may also want to minimise any non-essential “lifestyle costs” such as take-aways, dining out and subscriptions. The more disposable income you can show, the more likely it is that you will pass the stress test.