What is a mortgage stress test?

If you apply for a mortgage, the bank will carry out a series of checks to determine whether you will be able to repay your debt. These are called credit assessments and are carried out by bank underwriters. Most of the process focuses on assessing whether you will be able to repay the mortgage under current market conditions (interest rates, inflation). However, the bank wants to be sure that the mortgage will not be at risk in the event of sudden market changes – this is why a stress test is carried out.

What is a stress test?

A mortgage stress test is a type of simulation designed to show whether a potential borrower will be able to repay their instalments in the event of an increase in interest rates, and thus the SVR (Standard Variable Rate), i.e. the interest rate set individually by each bank, to which the customer switches after the promotional period ends. Although the SVR does not automatically follow the Bank of England’s reference rates, they are a key factor in determining its value. So if the reference rates go up, the SVR will most likely go up with them.

This is therefore an additional part of the customer’s creditworthiness assessment, which helps the bank assess the credit risk in conditions that are less favourable to the borrower.

How does the stress test work for mortgages in the UK?

The form of the stress test varies depending on the type of mortgage product being considered. The most popular is, of course, the residential mortgage, which is intended for people who want to purchase property for residential purposes only.

To this end, a so-called stress rate is created, i.e. an interest rate that may arise as a result of market changes. The SVR is used for this purpose, to which a specific buffer is added – usually between 1% and 3%. Until recently, until August 2022, theFCA (Financial Conduct Authority) imposed a fixed buffer of 3% on lenders. This was a universal, fixed rule that every bank had to follow when performing a stress test. After that date, the FCA removed this requirement, allowing institutions greater flexibility in their assessments. As a result, banks often apply a lower buffer, which works to the advantage of borrowers, as the stress test has become easier to pass.

Based on the stress rate, the bank calculates the monthly instalment and compares it again with the customer’s financial situation. This process is similar to the first steps taken when assessing creditworthiness, except that the mortgage instalment is much higher. If the calculations show that the customer has sufficient disposable income after paying all fixed expenses, including the stress rate, the stress test is passed. However, if it turns out that the liabilities consume too large a portion of the customer’s income, the test is considered failed.

How does this look in figures?

To illustrate an example of a stress test, let us use an example. Consider the following situation involving Mr David:

Mortgage amount £200,000 Mortgage period 25 years Promotional fixed rate (for 2 years) 4,5% SVR 7% Customer’s monthly income (net) £3,500

To conduct a stress test, the bank must determine the stress rate and use it to calculate the appropriately inflated monthly instalment. Let us assume that the bank uses a buffer of 2%. This means that the stress rate is 7% (SVR) + 2% = 9%. In this case, the monthly instalment will be £1,678.

Once the bank knows the monthly instalment amount, it must check how much free cash Mr David will have left after deducting all his monthly expenses and liabilities. From the amount of £3,500, it deducts the so-called stress costs, i.e. the mortgage instalment and, for example:

• car loan instalment - £400;

• living expenses - £850;

• private medical insurance (PMI) premium - £20.

With a salary of £3,500, Mr Dawid would have £552 of disposable income. Pass rates depend on the minimum set by the bank, but this is usually between £350 and £500 per adult, so it is likely that he would pass the test.

Stress test and investment mortgage

The situation is slightly different when it comes to investment mortgages, i.e.Buy to let. The difference stems from the different way in which creditworthiness is assessed for such products. While in the case of housing mortgages, the borrower’s financial situation is mainly checked, in the case of Buy to let mortgages, attention is focused on the potential return on investment.

So how is a stress test carried out for a buy-to-let mortgage?

The first step taken by the bank is to commission an expert to determine the real market value of the monthly rent (while valuing the property). This amount will be the key factor that ultimately determines the outcome of the test. Next, as in the previous case discussed, the bank will determine the stress rate, which will form the basis for calculating the monthly interest.

A very important factor that appears in the stress test for a BTL mortgage is the ICR (Interest Coverage Ratio), which shows the minimum surplus by which the rental income must exceed the mortgage cost calculated at the stress rate. Its value will vary depending on the borrower and their tax situation, e.g.:

• for a private individual (including the self-employed) in the first tax bracket (Basic Rate), 125% of the ICR will usually be required - this value is often considered safe;

• for individuals in higher brackets, i.e. Higher Rate and Additional Rate, this will usually be 140% and 145% respectively;

• if the mortgage is to be taken out by a Limited company, the required ICR will usually be lower than for high-income individuals due to lower tax burdens.

To conduct a stress test, the most important calculation is to calculate the annual interest cost and compare it with the ICR ratio. To illustrate this best, let’s use an example - let’s assume that Mr Christopher wants to take out a Buy to Let mortgage for £200,000:

Mortgage value £200,000 Bank stress rate 7,5% Tax status of Mr Christopher Additional Rate (the rate of Income Tax is 45%) Required ICR 145% Estimated monthly rent £1,250

First, the bank must calculate how much interest Mr Christopher will pay per year. To do this, it multiplies the mortgage amount by the stress rate:

£200,000 * 7.5% = £15,000

Next, the minimum annual rental income that the property must generate to pass the 145% buffer test is calculated:

£15,000 * 145% = £21,750

Dividing this amount by 12 months gives the minimum monthly rent - £1,812.50

As you can see, the required monthly income is higher than the rent estimated by the valuer. Although Mr Christopher could easily repay the interest and generate income under the initial conditions, the stress test showed that if the SVR increased, the investment would no longer be as profitable and the mortgage would be at risk. An additional factor here is the large buffer of 145% - Mr Christoph would probably have a better chance of obtaining a mortgage if he set up an LTD company - then his tax burden would be lower, and so would the bank’s ICR ratio.

What can you do if your mortgage application fails the stress test?

Unfortunately, sometimes the stress test will show a negative result, which will drastically reduce your chances of obtaining a mortgage on the expected terms. Fortunately, this does not mean that the prospect of obtaining financing will disappear completely. Regardless of the type of product, there are two universal options that give you a better chance of passing the stress test:

• Extending the mortgage term – a popular option for solving this problem is to agree with the bank on a longer financing period for the same mortgage amount. This is a simple mechanism that will reduce your monthly instalment or monthly interest amount.

• Reducing the mortgage amount – if you have more savings that you could use as a down payment, it would be a good idea to reduce the LTV ratio of the mortgage. This will reduce its monthly cost while keeping the mortgage term the same.

If you are taking out a mortgage, remember that your personalcreditworthiness is very important. Taking steps to improve it may ultimately help you make up for the gap in your disposable income and pass the test.

Additionally, in the case of investment mortgages, there are several mechanisms that are worth considering in such a situation:

• Top Slicing - Top Slicing is an interesting option that helps investors obtain financing. This mechanism involves using your personal income to cover the shortfall in the stress test. Some banks agree to this solution, especially if the investor has an attractive financial situation.

• **Choosing a mortgage with a longer promotional interest rate period **- this may seem confusing, but a longer promotional period is associated with a lower stress rate, due to the lower risk for the bank in the following years;

• The last aspect that can help you pass the stress test is a change in your tax situation. As mentioned earlier, the taxes paid by the borrower have a direct impact on the size of the buffer in the ICR ratio. That is why a popular solution among high-earning investors is to set up a special purpose vehicle (SPV) that pays less income tax than the investor themselves.

Summary

A stress test is an inevitable part of any assessment of a potential borrower’s creditworthiness. It is worth knowing the rules on which it is based and how to respond appropriately if your application fails. Remember that the test differs greatly between residential and investment mortgages – for a residential mortgage, the most important factors are your creditworthiness and the amount of so-called free cash after paying the instalment. In the case of buy-to-let mortgages, on the other hand, the most important factor is the expected return on investment.