Many lenders wanted The Financial Policy Committee to relax the residential mortgage stress test introduced in 2014 and so when it announced a tighter test in July it surprised the market.
The 2014 announcement required lenders to stress mortgage applications, unless the initial rate was fixed for at least 5 years, based on a 3% rise in Bank Rate. Since 2014 the interest rate outlook has become even more benign, which is why lenders wanted some relaxation.
The initial test had little impact because most lenders were already stressing on a similar basis and those with a high SVR had flexibility if their business plan showed smaller planned increases in their SVR than Bank Rate.
Taken at face value the FPC’s imposition of a tighter stress test appears odd, unless it expects the MPC to increase Bank Rate quicker than current market expectations, and there is no evidence of this. Therefore, I suspect the decision to tighten is rather more nuanced.
Behind the scenes the Prudential Regulation Authority, which works closely with the FPC and regulates the vast majority of mortgage lending, has been pressing lenders to apply even more conservative lending policies than the rules require.
The FPC claims that some lenders have been gaming the system and has therefore changed the rule to require lenders to assume a 3% increase in their “revert to” rate, which in most cases will be their SVR. The main exception, in addition to mortgages where the initial rate is fixed for at least 5 years, is for mortgages without a “revert to” rate, e.g. term trackers.
Therefore, the minimum stress test rate for a mortgage at Bank Rate + 2% for term will be 5%, whereas if the same lender’s SVR was 5.5% and it offered a 2 year fix at 1.25%, reverting to SVR, the stress test would have to be at 8.5%!
Few lenders have used the flexibility to apply a lower stress rate if the initial rate is fixed for at least 5 years. This doesn’t surprise me as in the current low inflation environment, with small salary increases, lenders can no longer expect wage inflation to significantly improve affordability over a period as short as 5 years. However, using this flexibility for 10 year fixes would have some merit, but lenders are not doing this either.
The 5 year cut off point for applying a stress test was set by the FCA in the Mortgage Market Review just before the FPC introduced its stress test. It was logical for the FPC to dovetail its macro prudential rules with the MMR’s conduct rules and hence also use 5 years as the cut-off point. However, without that constraint I doubt the FPC would have excluded fixed rates of at least 5 years.
The smaller building societies will be most affected by the tighter stress test, because they generally have higher SVRs. If they are no longer able to compete for some borrowers’ business one option may be expanding into niche areas.
Ray Boulger, Senior Technical Manager, John Charcol