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Do lending decisions based solely on affordability encourage borrowers to overstretch themselves?

 

Mehrad Yousefi is head of intermediary mortgages at Alliance and Leicester

Affordability-based lending is fast becoming the norm in the mortgage industry, and with good reason.

It is the most responsible and accurate way to work out how much a borrower can afford as it is based on their individual circumstances. This type of lending decision takes into account factors such as an individual’s gross income and monthly expenditure as well as the region they live in and the number of dependants they have. The lender is then in a position to know exactly what can be comfortably afforded.

Affordability generally provides greater flexibility to households with a higher disposable income, less so for those with a high level of debt. Furthermore, most sophisticated affordability models build in stress factors such as an increase in interest rates and changes to circumstances which means overstretching is extremely unlikely.

A common measure of affordability was always the house price to earnings ratio. A similar measure is expressed in income multiples. But against a backdrop of low interest rates, low inflation and steady growth, a better measure is the proportion of income needed for monthly mortgage payments – affordability.

Lower interest rates mean households pay cheaper mortgage repayments. Since 2000, mortgage interest rates have averaged 6%. This compares with 9% in the 1990s and 12% in 1980s. The corresponding monthly payments on a 100,000 loan at these interest rates are 490, 640 and 800. This shows that at the current average, a household can afford a much larger mortgage than it could in the 1990s.

Most households are able to service a larger mortgage despite the same level of earnings as a result of lower interest rates. This is why affordability is so much more accurate and responsible than income multiples.

Kevin Hillgren is chief executive of Victoria Mortgages

In the modern mortgage market, the mantra ‘one size fits all’ no longer has any bearing. In response to changes in customer demand, lenders are continually launching products offering a range of pricing alternatives and payment schemes. The only constant in our market seems to be some lenders’ income multiples.

In the pre-Mortgage Day world, income multiples served a useful purpose. They provided a gauge of how much a customer would likely be able to borrow and because of their simplicity brokers could do the sums on the back of beer mats. Even today, income multiples are a tool that can be used effectively. Brokers can explain to their clients the implications of increasing levels of debt on their cash flow and lenders can assess clients’ total leverage.

But income multiples are at best a snapshot of affordability in a stable interest rate environment and are a poor proxy for cash flow analysis. Interest rates have changed since income multiples were introduced and are likely to continue to fluctuate. The basic living expenses of a single person in Cumbria are likely to be different than for a family in Chelsea. Family demographics have also evolved. Double income families are now the norm rather than the exception. We must question why many lenders will loan 5 x the first applicant’s income but only 1 x their partner’s.

A robust affordability calculation provides a more accurate measure of whether a mortgage is affordable. Income multiples cannot hope to take into account interest rate changes and variations in household expenses. The better affordability calculators consider taxes, too.

But we must remember that even with the most responsible lending and the most accurate affordability calculators, it is impossible to prevent clients taking out additional unsecured debt.

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