TL;DR
In short
- A mortgage stress test checks whether you could still afford your mortgage payments if interest rates, and therefore the SVR (Standard Variable Rate), went up.
- Lenders set their own stress rate. It is often based on the reversion rate (such as the SVR) plus a margin, and the margin varies between lenders.
- Until 1 August 2022, a Bank of England Financial Policy Committee recommendation required larger lenders to test affordability at 3 percentage points above the reversion rate. That test has been withdrawn, but FCA rules still require lenders to take into account likely interest rate rises over the first five years, unless the rate is fixed for five years or more.
- For buy-to-let mortgages, the lender mainly checks whether the expected rental income covers the mortgage interest at the stress rate, measured by the interest coverage ratio (ICR).
- If you fail the stress test, a longer term on a repayment mortgage or a smaller loan may help; for buy-to-let, top slicing or a rate fixed for five years or more may also help.
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 do this, the lender works out a so-called stress rate, i.e. a higher interest rate that could apply if market rates rise. Lenders set their own stress rate. It is often based on the reversion rate (such as the SVR) that the mortgage would move to after the initial deal, plus a margin, and the margin varies between lenders. Until 1 August 2022, a Bank of England Financial Policy Committee recommendation required larger lenders to check that borrowers could still afford their payments if their mortgage rate rose 3 percentage points above the reversion rate during the first five years. That test has been withdrawn, but FCA rules still require lenders to take into account likely interest rate rises over the first five years, unless the rate is fixed for five years or more. Each lender now decides how to apply this in its own affordability assessment.
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?
Here is a simple example of a stress test. Consider the following situation involving Mr David:
| Item | Value |
|---|---|
| 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:
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car loan instalment - £400;
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living expenses - £850;
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private medical insurance (PMI) premium - £20.
With a salary of £3,500, Mr David would have £552 of disposable income. Lenders set their own minimum level of disposable income, so whether Mr David passes depends on the lender’s affordability model. If, for example, the lender required at least £500 of disposable income in his situation, 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 residential mortgages, the borrower’s financial situation is mainly checked, in the case of buy-to-let mortgages the lender focuses mainly on whether the expected rental income covers the mortgage interest at the stress rate, although some lenders may also take your personal income into account.
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.:
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for an individual borrower (including the self-employed) who pays basic-rate income tax, 125% is a common minimum ICR;
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for higher-rate and additional-rate taxpayers, lenders may require a higher ICR (for example 145%), because they take the borrower’s tax position into account;
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if the mortgage is taken out by a limited company, the lender may apply a different ICR, because the company’s tax position differs from an individual’s.
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:
| Item | Value |
|---|---|
| Mortgage value | £200,000 |
| Bank stress rate | 7.5% |
| Tax status of Mr Christopher | Additional Rate (45% income tax in England, Wales and Northern Ireland) |
| Required ICR (assumed for this example) | 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. In this example, the 145% ICR reflects Mr Christopher’s tax position. Some lenders apply a different ICR to limited-company borrowers, but whether buying through a company suits you depends on your overall tax and financial position, so take independent tax advice before choosing this route.
What can you do if your mortgage application fails the stress test?
Unfortunately, sometimes the stress test will show a negative result, which can reduce your chances of obtaining a mortgage on the terms you expected. Fortunately, this does not mean that the prospect of obtaining financing will disappear completely. Two common options that may help you pass the stress test are:
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Extending the mortgage term – on a repayment mortgage, agreeing a longer term for the same loan amount reduces the monthly repayment, although you will usually pay more interest in total over the life of the mortgage. On an interest-only mortgage, a longer term does not reduce the monthly interest.
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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 personal creditworthiness 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:
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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.
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Choosing a rate fixed for five years or more – for rates fixed for five years or more, lenders may not have to apply the same interest-rate stress, which can make the test easier to pass;
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The last aspect that can help you pass the stress test is a change in how you buy the property. As mentioned earlier, the borrower’s tax position can affect the ICR a lender requires. Some investors buy through a limited company (a special purpose vehicle (SPV)), which pays corporation tax rather than income tax on its profits. Whether this suits you depends on your circumstances, so take independent tax and legal advice first.
Summary
A stress test is usually part of a lender’s assessment of whether a mortgage is affordable. If your rate is fixed for five years or more, the lender may not need to apply the same interest-rate stress. 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 key question is whether the expected rent covers the mortgage interest at the stress rate (the interest coverage ratio).
FAQ
Frequently asked questions
What is a stress test?
A mortgage stress test is a simulation that shows whether a borrower could still afford their mortgage payments if interest rates, and therefore the SVR (Standard Variable Rate), went up. It is an additional part of the lender’s creditworthiness assessment.
How does the stress test work for mortgages in the UK?
The lender works out a stress rate, i.e. a higher interest rate that could apply if market rates rise, often based on the reversion rate (such as the SVR) plus a margin that varies between lenders. It then calculates the monthly payment at that rate and checks whether you would still have enough disposable income after your fixed expenses. FCA rules require lenders to take into account likely interest rate rises over the first five years, unless the rate is fixed for five years or more, and each lender decides how to apply this.
What does a mortgage stress test look like in numbers?
In the example above, Mr David borrows £200,000 over 25 years with an SVR of 7%; with an assumed 2% buffer, the stress rate is 9% and the monthly instalment is £1,678. After that instalment and his other monthly costs, he would have £552 of disposable income left from his £3,500 net monthly income, so he would pass if, for example, the lender required at least £500.
How does the stress test work for buy-to-let mortgages?
The lender mainly checks whether the expected rental income covers the mortgage interest at the stress rate, measured by the interest coverage ratio (ICR). 125% is a common minimum ICR for basic-rate taxpayers, and lenders may require a higher ICR (for example 145%) for higher-rate and additional-rate taxpayers.
What can you do if your mortgage application fails the stress test?
A failed stress test can reduce your chances of obtaining a mortgage on the terms you expected, but it does not mean that financing is ruled out completely. Two common options that may help are a longer term on a repayment mortgage (although you will usually pay more interest in total) and a smaller loan with a larger down payment. For buy-to-let, top slicing or a rate fixed for five years or more may also help.
