The Mortgage Market Review (MMR) implemented in April 2014 marked the biggest regulatory change within the mortgage market following the Financial Crisis of 2008. In an effort to control lending practices within the Financial Services industry, which were believed to have contributed to some of the issues surrounding the Financial Crisis, the FCA strengthened Responsible Lending rules within the Mortgage and Home Finance Conduct of Business Sourcebook (MCOB) to ensure mortgages would be subject to more stringent affordability checks, particularly regarding stressed interest rates.
The overall value of the mortgage market currently stands at c.£1.601tn as of September 2021 with house prices starting to grow (c.10.8% as at December 2021) at rates similar to those seen in the lead up to the Financial Crisis in 2008. Whilst some of this growth in house prices has been linked to the COVID-19 pandemic and consumers having more disposable income as a result of lockdowns and government support schemes, there has also been a relaxation in lending criteria at some lenders (for instance, increased maximum age, increased mortgage terms and increased loan to income ratios) in an attempt to increase their market share and compete within the mortgage market which has also contributed to this house price growth. With consumer prices already rising at their highest rate for 30 years, creating further pressure on household affordability, firms need to ensure they have appropriate affordability and credit risk controls in place to lend responsibly but not put unnecessary barriers in place for those customers who can genuinely afford it. This area has always been a priority for regulators and is likely to receive increased regulatory attention as the real income of consumers reduces during 2022 and beyond. This blog highlights some the key areas that firms need to consider when assessing a customer’s ability to repay their mortgage throughout the lifetime of the product.
The assessment of income is often a relatively straightforward task, especially for those that are employed, as their salary will typically be clear on their payslips and P60s, and is normally consistent and reliable. The uncertainty typically arises where there is a reliance on income that may be variable such as commission/bonus income or overtime. Complexities can also arise where the customer may have non-standard income patterns such as those who are self-employed, a company director in receipt of dividend payments, a contract worker, or heavily reliant on investment income from other sources (such as a portfolio landlord or an investment portfolio). In these instances, there may be the need to apply a greater level of due diligence to verify and scrutinise the sustainability of this income further than you would for a standard customer. This can make assessing affordability more challenging, with affordability calculated on more volatile incomes sources that have not been appropriately scrutinised or understood to determine whether this income is sustainable and appropriate to use to assess affordability. We have observed instances where the appropriate level of due diligence has not been undertaken and affordability has instead been based on a limited sample of information to assess non-standard income. For instance, payslips covering a limited period of time have been used to assess variable income such as bonuses/commission or overtime and also accountant’s projections have been used without appropriate challenge or validation of company/management accounts to determine whether the figures are realistic and sustainable. Firms should take into consideration the following as part of their assessment of income:
- How do you assess income for employed customers with non-standard income streams to ensure that the income is sustainable throughout the mortgage term?
- How do you ensure that any dividend income for company directors is sustainable in line with company profits?
- How do you assess that any investment income from investment and property portfolios is sustainable in volatile market conditions?
The assessment of expenditure is a more detailed task than assessing income as regulation requires consideration of three separate elements within the affordability assessment; committed expenditure, basic essential expenditure; and the basic quality-of-living costs for households. Whilst the committed expenditure is often assessed using a data feed from the credit reference agencies, sometimes supported by a manual review of bank statements, there is a reliance on expenditure models to support with the assessment of basic essential expenditure and any quality-of-living elements. The recent COVID-19 pandemic and spike in inflation experienced in 2021/22 has shown how quickly traditional assumptions around expenditure can be disrupted however and such models can become unreliable or out of date very quickly. The majority of lenders rely on household spending data from key sources such as Office for National Statistics (ONS), Joseph Rowntree or Open Banking applications, as a key input into their expenditure models. However, we have observed instances of lenders failing to update their expenditure models following the latest publication of this data. This data is often only produced on an annual basis and reports family spending patterns 12 months in arrears which is unlikely to take into consideration any unexpected rise in consumer prices or interest rates, an increase in household spending or a deterioration in other leading economic indicators. Without having appropriate economic triggers defined to review the expenditure models, firms may be basing their lending decision on inaccurate household composition data which may lead to unaffordable lending. As such, firms need to have processes and controls in place to ensure that the models and the data that they use remain accurate and are reviewed and amended more frequently than in a stable economic environment and mitigating controls are put in place to account for these variances. These models should also be validated following any changes. These controls are vitally important to ensure lenders continue to make responsible lending decisions based on accurate data, especially as the UK economy is currently experiencing a cost-of-living crisis. Firms should take into consideration the following as part of their assessment of expenditure:
- How often should expenditure models be subject to review to ensure accurate figures are used in affordability calculations?
- How do you take into consideration any rise in the cost of living within any calculation of expenditure which may not be picked up by models?
- Which leading economic indicators do you track and at what point would a deterioration in these cause you to review and update your expenditure models?
- What validation controls do you have in place to ensure the calculator is working as intended in line with policy?
The FCA has acknowledged that affordability assessments are not an exact science, and that implications outside of normal control, such as an unexpected change in the customer’s circumstances or wider economic events can impact affordability. There remains a challenge for firms to strike the right balance of eliminating lending that is foreseeably unaffordable, without having a process that may be so conservative as to decline applications where lending is and would most likely continue to be affordable.