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.

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