UK mortgage affordability rules: why has Bank of England scrapped test for home buyers as interest rates rise?

The Bank of England has changed rules for mortgage affordability tests as part of a bid to cut red tape during the mortgage application process.

The move has raised eyebrows as it comes at a time of rising interest rates and a major cost of living crisis sparked by soaring inflation.

House prices are also continuing to outpace wage growth, with the average property now over £55,000 more expensive than before the Covid pandemic and 8.7 times the average annual UK income.

So what exactly does the Bank of England’s announcement mean - and what could it mean for you?

Here’s what you need to know.

What is a mortgage affordability test?

When you apply for a mortgage, lenders have to stress test your finances to see if you can repay the loan.

This process was bolstered in the wake of the 2007-2008 global financial crisis, due to the crash being partly caused by US banks making risky loans to people who then struggled to pay them back.

According to the Bank of England, high levels of indebtedness can “amplify” a recession because households struggling to pay off debt usually end up drastically cutting back their spending in economic downturns.

In 2014, the UK introduced two mortgage mechanisms to reduce the risk of this kind of eventuality.

These were:

• A stress interest rate for lenders when assessing prospective borrowers’ ability to repay a mortgage (i.e. a check to see whether they could cope with higher interest rates)
• A loan-to-income (LTI) limit, which caps the number of mortgages that can be given to borrowers at LTI ratios at or greater than 4.5 - a measure that is designed to protect lenders from collapsing if too many borrowers cannot repay their loans

What has changed with mortgage affordability tests?

The Bank of England has announced that the ‘stress test’ mechanism will be scrapped, leaving only the LTI limit as a way to ensure borrowers can repay what they owe.

The change is set to come into effect from Monday (1 August).

Explaining its decision, the independent public body explained that ditching the test would retain an “appropriate level of resilience to the UK financial system” while also making mortgage rules “simpler, more predictable and more proportionate”.

The Bank’s Financial Policy Committee (FPC) has judged that the LTI limit is likely to have a larger role than the stress test in preventing a rise in overall household indebtedness and the number of highly indebted households in a scenario of rapidly rising house prices.

It also believes the LTI limit will be enough alongside the wider assessment of affordability required by the Financial Conduct Authority (FCA)’s responsible lending rules.

A consultation looking at the impact the change could have on mortgage lending was launched by the Bank of England in February, with the organisation reporting the majority of responses were supportive of the change.

What do mortgage affordability rule changes mean for you?

It is unlikely that prospective borrowers will notice any immediate changes when the rules change.

The Bank of England has said lenders will not need to make any changes, as their existing checks should already comply with the FCA’s responsible lending rules.

According to Gemma Harle, MD at Quilter Financial Planning, the change could have the effect of making it harder for first time buyers to get on the property ladder.

“One of the main drivers behind ‘generation rent’ is the fact that house prices have massively outstripped wage growth. Due to high house prices, first-time buyers also need very sizable deposits,” she said.

“In the current fiscal environment saving this type of money will be very difficult due to increasing rents and the cost of living. On top of this, inflation will be eating away at any other savings they have sitting in cash.

“House prices have become further and further out of reach for prospective buyers and this change in the affordability rules could perpetuate unsustainable further growth as it steps up demand in a market already suffering with limited stock.”

Data from Rightmove that was released in June showed the average asking price across Britain stands at £368,614.

The June data marked the fifth month in a row that prices hit a record high.

However, HMRC figures suggest the housing market may be cooling, with transactions 5% lower in May 2022 than in May 2021.

Property purchases remained above 2019 levels, according to the data.