Currently, borrowers are subjected to two tests when taking out mortgages which were introduced by the Financial Policy Committee (FPC) in 2014 to “guard against a loosening in mortgage underwriting standards” which could lead to an increase in household debt.

The Bank of England has launched a consultation to withdraw the affordability test while keeping the Loan-to-Income flow limit as it “ought to deliver an appropriate level of resilience to the UK financial system, but in a simpler, more predictable and more proportionate way.”

Borrower and lender tests

One test is the Loan-to-Income (LTI) ratio which refers to how much the mortgage applicant can borrow relative to their annual income. Typically, this stands at 4.5%, though lenders can extend this LTI ratio to 15% of new mortgage lending.

The second is the affordability test which specifies a stress interest rate for lenders when assessing prospective borrowers’ ability to repay.

This tests whether they could still afford their mortgages if at any point over the first five years of the loan, the mortgage rate was to be three percentage points higher than the reversion rate.

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The Bank of England has launched a consultation on withdrawing the FPCs affordability test, while it maintains the LTI recommendation.

It said the LTI limit is “likely to play a stronger role than the affordability test in guarding against an increase in aggregate household indebtedness and the number of highly indebted households when house prices rise rapidly”.

Concerns and uncertainty

The move comes as the Bank revealed the affordability test could have caused around 6% of borrowers – roughly 30,000 per year – to take out smaller mortgages than they would have been able to in the absence of the test. Most of those constrained by the affordability test took out mortgages with LTI ratios of under 4.5.

Further, its analysis revealed that 83% of renters currently lack the savings to raise a 5% deposit themselves. A further 6% would be able to raise a deposit, but are not currently able to meet affordability assessments.

The Bank said it had “concerns” with how the affordability test has operated. It said: “The stress rate encapsulated in the test has remained broadly static, reflecting stickiness in reversion rates despite the fall in average quoted mortgage rates. This demonstrates that there is considerable uncertainty about how the stress rate encapsulated in the affordability test might move in future, and in turn about the effect the test could have.”

However, while the absence of the FPC’s affordability test would make things “simpler, more predictable and would reduce the impact on a small proportion of borrowers”, the Bank said responsible lending rules in place under the Financial Conduct Authority’s Mortgage Conduct of Business (MCOB) “would remain as an appropriate affordability check”.

It stated: “A lender must also assume that interest rates rise by a minimum of 100 basis points during the first five years of the mortgage. In the event that the FPC decides to withdraw its affordability test Recommendation, MCOB rules on responsible lending would continue to apply. The only change would be that, for lenders considering the effect of future interest rate rises, there would be no prevailing FPC Recommendation on interest rate stress tests to have regard to.”

‘Looks like a risky move’

Sarah Coles, senior personal finance analyst at Hargreaves Lansdown, said: “The Bank of England plans to ditch a rule designed to limit massive mortgages. Letting people borrow more money looks like a risky move at a time when house prices are sky high and the outlook is uncertain. But the Bank is convinced the extra test isn’t fair any more, and that without it, there are still enough protections in place.

“The FPC’s affordability tests have seemed increasingly draconian over time, because they refer to reversion rates – the mortgage rate you’re moved to at the end of your deal. Despite mortgage rates dropping dramatically in recent years, reversion rates have remained remarkably sticky, so in order to qualify for a cheap mortgage, buyers need to prove they can afford a really expensive one.

“The worry is that this could mean more people able to borrow more money, which could make them vulnerable to over-stretching themselves to afford sky-high prices. Any weakness in the property market in the coming months could add the risk of negative equity for those who have borrowed much more. However, the Bank calculates that a combination of the FCA’s affordability rules and its own rule that limits the number of mortgages with a high loan-to-income will offer enough protection.”

The consultation closes on 6 May 2022. If a decision is taken to withdraw the affordability test, it would be expected to take effect within 12 months.