A house is the most expensive thing you are likely to buy in your lifetime but, luckily, mortgages allow you to space out your payments over a long period of time.
However, this doesn’t necessarily mean that a house is affordable to you. It’s very important that you understand exactly what risk you’re facing: if you fail to make your mortgage payments, you could lose your home.
Calculating affordability used to be much easier. Time was, you would use a loan-to-income ratio to work it out affordability. So, if you earned £50,000, you would be able to borrow between three and five times that amount – in this case, up to £250,000. This is still helpful as a guide, and you can use our online calculator to find out how much you can borrow based on you and your partner’s income. These days, however, lenders need to use an affordability assessment and ‘stress test’.
“Lenders are now legally obliged to test whether or not a borrower can afford a mortgage”
In June 2017, The Bank of England was worried that, with the low-interest rates, lenders will be lulled into a false sense of security and start offering high-risk mortgages. For this reason, the BoE introduced new rules. Lenders are now legally obliged to test whether or not a borrower can afford a mortgage before they can offer one. The test isn’t only based on the current climate, either – it is designed as a stress test to check the borrower’s ability to manage potential increased interest rates throughout their mortgage. The BoE’s new rules mean lenders need to apply an interest rate stress test of 3 percentage points above the rate that will apply when the introductory mortgage offer ends.
If a lender thinks you might not be able to afford your mortgage they could reject your application or limit the amount you can borrow. That’s why it’s essential that you check that you can afford the mortgage by calculating your own ‘stress test’.
When performing your own stress test, don’t just think about the cost of the mortgage. Remember to consider other costs of buying a new home, such as moving expenses or house maintenance and building costs. We have made a complete list of hidden costs when buying a property here. But it’s not just the immediate expenses you need to incorporate into your calculation. What are your monthly outgoings? This includes credit cards, insurance, bills, loans, and an estimated cost of living. You need to compare this to your income, from jobs, pension, investments, forms of financial support, and income of a second applicant if you have one. Take the difference between these two, and you’ll have a rough budget for the mortgage.
With this figure, you’ll need to take the maximum interest rate on the mortgage deal you are expected (i.e. after the introductory offer has expired) and add 3 percentage points to it. Let’s say, as an example, that your Mortgage is £300,000 over 25 years and the interest rate is 5.5%. In this case, you need to calculate your monthly payments at 8.5% interest. This is a tricky calculation to make because the interest you pay will change as you pay back your mortgage. Luckily, Coreco has a few more handy calculators to help you. Our Mortgage Calculator shows us that a £300,000 mortgage at 5.5% would mean monthly repayments of £1842.26. However, a stress test would require you to be able to afford 8.5% interest, which comes to £2,415.68. If your budget is significantly higher than this number, you should have less to worry about. If it’s equal to or less than this number, then you will need to think about if you can afford this mortgage.
At this point, we should mention that, if your mortgages rate is fixed for five or more years, then a stress test is not required. Because of this, you could potentially borrow more. However, you would also be hit with the other pros and cons of fixed-rate mortgages, such as higher interest rates but peace of mind that your rate cannot increase.
If you’re not sure if your calculations are correct, or you would like better clarity, or even if you think you should be able to get a better mortgage deal, then why not speak to us and get some expert advice? Our brokers will be able to tell you exactly what you can expect based on your circumstances, and may bring up crucial factors you might have missed. Get in touch with us via our contact page to find out more!