What is affordability? All about creditworthiness in the UK

We mention affordability very often on our blog. We publish many posts that at least partially mention creditworthiness, so in order to make our experts’ advice clearer, we will devote a little more attention to this topic. So what is affordability, what affects it and what you can do to improve this indicator.

What is affordability?

According to Moneyhelper, affordability is the amount you are able to borrow from the bank in the form of a mortgage. It is a parameter derived from the borrower’s income and expenditure. Neither the regulations nor the recommendations of the FCA (Financial Conduct Authority) impose a maximum or minimum affordability - each bank makes its own rules on this and in some cases, at the Decision in Principle stage, the mortgage underwriter may deviate from the set rules, for example due to the particular financial situation of the borrower.

What is affordability?

From an expenditure analysis perspective, affordability should be interpreted more as the ability to pay instalments of a certain amount. The mortgage instalment cannot be too large a proportion of your earnings - it is usually assumed that it should be no more than 45% of your pre-tax income or 35% of your after-tax income. The exact figures depend on the statistical cost of living in your area and an analysis of the borrower’s expenses, but one thing is certain - it is very difficult to get a mortgage whose instalment will be 80% of your monthly budget.

How much is my affordability?

The general rule of thumb is that the maximum amount cannot exceed 5 times the borrowers’ annual earnings. This fairly universal assumption usually holds true, which is why this is the formula our calculator uses.

However, it is worth noting that banks in their own way favour those with above average earnings - a married couple earning £250,000 a year will be able to borrow a much larger amount relative to their income than a couple with an income of £70,000. The reason for this is simple - in the event of a sharp rise in interest rates, a wealthy borrower will be able to reduce their spending and therefore, the risk of having problems repaying the mortgage is simply lower.

Exactly the same applies to age - your affordability will be higher the younger you are. A 25-year-old will be able to repay their mortgage for 30 or 35 years, whereas someone in their 50s will get a mortgage for a much shorter period. This is one of the reasons why it makes sense to decide to buy a property as early as possible, although it obviously involves a lot of financial effort.

In practice, affordability can range from 3 times to as much as 7 times the annual income of those applying for a mortgage.

What credited incomes affect affordability and how?

It is important to remember that banks differentiate between sources of income and the actual affordability may be much lower or higher than it appears. Let’s now discuss some of the most common ways to raise affordability.

What credited incomes affect affordability and how?

Working on a permanent basis

Income from a salaried job is calculated according to a ‘standard’ conversion rate - affordability will be between 4.5 times and 5 times your annual salary, unless of course you have special obligations. Particularly well-paid professionals will be able to borrow a little more than 500% of their income - sometimes as much as 700%. On the other hand, banks with strict underwriting criteria may reduce this figure to as little as 300%.

Income from overtime and self-employment

Income from overtime and self-employment can be considered less stable and, although they raise affordability, their impact on this parameter is simply weaker. This is a big problem for certain occupational groups, for example, truck drivers and construction workers, because typically, they receive a low basic salary, which is clearly raised with overtime allowances.

It is safe to assume that in these types of cases, overtime pay will count similarly to half the salary of a full-time employee. For the self-employed, affordability compared to earnings will be higher, but not as high as for full-time employees.

Dividends

In the case of dividend income, the situation gets a little more complicated. As a general rule, banks take them into account when calculating affordability, but a lot also depends on the source of the funds.

If you receive dividends as a director of a Ltd company, in principle it will be treated similarly to income from work - banks are aware that this is a popular way of withdrawing funds from your own company due to the tax preferences provided by the regulations.

The situation becomes more complicated, however, if you are applying for a mortgage using income from your investments. Dividends received from holding shares in listed companies also affect affordability, but the pool of banks accepting this source of income is limited. In addition, not every company will be accepted - the underwriter needs to see that the dividend is paid regularly and has been for many years, and is based on the real performance of the business in question, not just a temporary investment opportunity.

Scholarships

It is worth bearing in mind that some (few) banks will count stipend income towards your affordability. Stipend income may be considered a less stable source of income than, for example, self-employment income, but in such situations, you will almost always be asked to provide additional documents that will allow analysts to understand how your financial situation will evolve in a few years’ time.

What can you do to improve your affordability?

Let us point out at the outset - it is not worth trying to fool the analysts. The Decision in Principle process is so detailed that it is likely that your attempts to colour some details will be caught out and you may face serious consequences for doing so. However, there are a few perfectly legal ways that are definitely worth reaching for.

What can you do to improve your affordability?

Pay rise or change to a better paid job

It’s obvious - if you earn more, your affordability will increase. From a mortgage underwriter’s perspective, the provisions of the employment contract and the increase in base salary are very positive signals. The increase translates into a long-term improvement in the borrower’s financial situation, whereas overtime is treated more as a temporary cash injection. In the first instance, therefore, you should consider whether it is possible to increase your base salary even a little.

Overtime income

Bearing in mind that overtime income also increases your affordability to some extent, consider whether you are able to work a few more hours a week. This is obviously not the best solution, but you may be able to borrow a few or even several thousand pounds more this way.

However, the bank may not accept all of your income if you turn out to be working, say, 80 hours a week - this is simply not sustainable in the long term, and after all, a mortgage is a long-term commitment.

Early repayment of loans and mortgages

Nothing ruins your creditworthiness as much as credit cards, instalments on a recently bought phone, a loan on a dishwasher or a lease on a car do.

If your current affordability translates into a monthly instalment of £1,000, while small loans cost you another £100 a month, you can assume that paying them off early will allow you to take out a mortgage with an instalment just about £100 higher. Of course, the difference could be much higher or lower in practice, but one thing is certain - no mortgage is good if we are talking about affordability.

Reducing expenditure

You are not able to avoid spending on groceries, electricity, water or transport. However, you’ll often find that unnecessary or ill-advised subscriptions, expensive services and luxury products are really taking away a lot of money that you could be putting aside or putting towards paying off your own home. Before you apply for a mortgage, try to analyse your spending - you’re almost certainly wasting money on something you could give up while maintaining your current living comfort.

How is it possible that I will have to reduce my spending?

Sometimes our clients wonder why the bank is reluctant to agree to give them a mortgage with an instalment that is similar to the rent they currently pay for their rented house or flat. The answer is extremely simple - it’s about risk.

Some people pay a disproportionate share of their earnings for rent, and the rent is often higher than the mortgage instalment for a comparable property. However, if interest rates were to rise sharply now, the situation could reverse, which would pose a real problem for the bank. For this reason, mortgage instalments cannot be too high. Private landlords are not so restrictive because they are not controlled by the FCA, making it easier to rent than to buy a flat.