Why some mortgage lenders including Paragon Mortgages Stress Test at 9% or more

by Property118.com News Team

9:24 AM, 5th January 2011
About 10 years ago

Why some mortgage lenders including Paragon Mortgages Stress Test at 9% or more

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Why some mortgage lenders including Paragon Mortgages Stress Test at 9% or more

Lenders and commentators – including the influential Paul Fisher, the Bank of England’s director of markets – are warning that the natural interest rate in a well-functioning economy is around the 5% mark.

With the Bank of England base rate stuck firmly at 0.5% since March 2009, many are worried that buy to let landlords have not subjected their property businesses to a robust stress-test to see what happens when rates go up.

The standard buy to let mortgage affordability test is 125% of the monthly rent which should cover an interest-only monthly mortgage repayment at a 5% rate.

The worry is most buy to let mortgage interest rates exceed that test even in the current low-rate environment and that a tougher test is needed if the sector is not to see hordes of landlords going to the wall.

Many standard variable rate buy to let mortgages are way above the headline rates for current fixed rate special deals offered at between 4.99% (Northern Rock) and 7% (Santander).

The interest coverage ratio (ICR) applied by buy to let mortgage lenders for a £100,000 interest only mortgage requires a monthly rent cover of £520 at the 125% ratio at a 5% mortgage rate. This is equivalent to a monthly mortgage payment of £416.

If the mortgage rate increases by 4.5% to 5%, then some might argue the ICR stress test should go up pro rata to 125% cover at 9.5% (the current 5% plus the 4.5% rise).

The new affordability figure then becomes £937 rent per month on a £100,000 interest only mortgage – requiring a monthly loan repayment of £750 per month, clearly way above any conceivable rent on an average letting property.

“With an affordability test at these levels, a loan will be fundamentally unaffordable once rates move much beyond their current levels, never mind once they hit 5% or more,” said John Heron of Paragon Mortgages.

“It’s not as if the market needs to be reminded of its responsibilities, but the FSA’s (Financial Services Authroity) Mortgage Market Review Distribution and Disclosure consultation paper again makes it very clear to lenders that the responsibility for undertaking a robust assessment of affordability rests with the lender.”

However, others believe that base rates will only start to rise when lending returns to some level or normality and the recovery is well underway.  Once lenders are competing for business again it is unlikely that they will be able to charge the same levels of interest as they are currently charging for new borrowing.  Therefore, as rates rise, margins will fall and people who have taken on debt at margins of over 2% will be incentivized to refinance again.  Therefore, if base rates do edge back up to 4% to 5% the pay rate is likely to come in at nearer to 6% or 7%.  To break even at this level, leaving a 20% margin between interest and rental payments it is advisable to stress test at 125% of 6% or 7%.  In a loan of £100,000 this would equate to a minimum rent of £625 to £730 and interst payments of £505 to £590.  To some investors this may also seem high.  However, if rental demand continues to rise, and there’s a good chance of that as ownership is likely to be less palatable to a lot more people as interest rates rise, these figures may begin to look more realistic.

What’s your view?


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Comments

19:03 PM, 6th January 2011
About 10 years ago

If a £100,000 mortgage represents 85% LTV would that property actually achieve rent of £625 pcm ?. if lenders are in the business of lending, surely they will have to adjust their stress test criteria in order that mortgage repayments will fit within the market rent achievable, or otherwise there is no lending that can be done because the figures don't stack up. Pre-2007/2008 the lenders were taking on some of the risk where rents and repayments were almost at parity (due to low stress test criteria) and house price inflation was expected to be the hedge against low profit margins, to keep the borrower motivated to be in the buy to let borrowing business. Now house price inflation is almost at or below zero, lenders will have to either take on risk again or stay out of the market. If inflation starts to rise significantly and interest rates rise to contain them, but house price values continue to fall, I don't see that encouraging further buy to let lenders to resume 'normal' lending levels due to rising interest rates in the stress test criteria reducing the amount that can be lent to borrowers, hence there will not be a significant increase in new rental properties being added into the market. Maybe rents will increase until lending criteria becomes acceptable again on the lenders terms ? I've also read that the massive loans that the BOE have provided to the major banks have to be repaid by the end of 2012, so the amount of money available for lending for home or buy to let loans will still be subdued because of this. I also think potential for rent rises are also held back because of the large number of properties that have become available for rent, such as improved properties that would have been bought by owner occupiers but have now been absorbed into the rental market as the potential owner occupiers cannot get mortgages. So perhaps a 'normal' functioning market can only return when the lenders have sufficient liquidity to resume the risk they were taking before 2007 / 2008. Does anyone see this as a likely development ?

19:30 PM, 6th January 2011
About 10 years ago

Thank you for your comments Steve. I think many of your questions and observations have been answered/supported in my other recent Blogs.

To make sure you don't miss any of the Headlines, if you haven't already done so, I recommend that you register to "Get Headlines Weekly".

I doubt we will see new but to let lending at 85% LTV for several years. Also, it's a lenders market at the moment. They don't need to take risks.


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