Daniel Norris, Elio Cucullo and Vasilis Jacovides
When borrowers enter a fixed-rate mortgage, lenders test whether they could continue to afford their mortgage if interest rates were to increase by the time it comes to re-fix. This ‘stressing’ is designed to create additional resilience for borrowers and the financial system. Over the last two years, mortgage rates have increased by over four percentage points, raising the cost of repayments for those re-fixing. We look at UK mortgage data and compare the stress rates applied at origination to rates available to borrowers when re-fixing. We find that the vast majority of borrowers who came to the end of their fixed terms in 2023 faced new mortgage rates which were lower than those they had been ‘stressed’ at.
This means that while these borrowers will still feel the squeeze of higher interest rates, their mortgage repayments are not as high as under the stressed scenario they were tested against. We find that this ‘headroom’ would remain for the majority of borrowers even at the peak level mortgage rates reached in 2023.
It is important to flag upfront that there is no direct consequence of having no stress rate ‘headroom’ eg it does not imply that borrowers would default or face no prospect of re-fixing; but there is less certainty about affordability. Likewise, having some ‘headroom’ does not guarantee that a borrower can afford a higher mortgage rate. Furthermore, the stress rate only accounts for one element of overall mortgage affordability. Increases in income improve affordability, while cost of living pressures squeeze affordability.
Borrowers are ‘stressed’ when they enter a mortgage
When applying for a mortgage, prospective borrowers are subject to an assessment that tests whether they would be able to meet their current and future mortgage payments if they were faced with higher interest rates in the future.
Most mortgages in the UK have a fixed rate for a period of time, typically two to five years. Once this period comes to an end, borrowers typically re-fix; however the rate available at this point may be different to their previous one. And this can have a big impact on monthly payments – a 3 percentage point rate increase on a £300k mortgage would set borrowers back by an additional ~£500 per month. So lenders ‘stress’ in advance whether borrowers would be able to continue to afford their mortgages if rates were to rise by the time they need to re-fix. The size of the ‘stress rate’ used by lenders is typically determined by their prevailing Standard Variable Rate (SVR) and a ‘stress buffer’ that is added on top of this, which is subject to a minimum level set by regulators. SVRs tend to move in line with changes to the Bank Rate.
Comparing average stress rates to mortgage rates
Mortgage rates have increased substantially over the last two years. The theoretical ‘stressing’ of borrowers’ ability to afford their mortgages is now being tested in practice. Were borrowers coming to the end of their fixed terms over the last two years tested at the rates they faced to re-fix?
Chart 1 shows the average stress rate (orange line) across all mortgages coming to the end of their fixed term over 2022–23, for example five-year fixes originated in 2017–18 and two-year fixes in 2020–21. The most common products in our sample are two-year fixes. The average stress rate is constructed based on regulatory data submitted by lenders on the stress rate they applied on each mortgage. The average stress rate is relatively stable across the period because at the point of origination SVRs were low and stable. Average stress rate is plotted alongside the new mortgage rate available (white line) for an individual re-fixing with a two-year fixed-rate mortgage. The new mortgage rate is constructed based on the average mortgage rates on offer at a range of loan to value levels (from 60% to 95%) across lenders. The gap between the average stress rate and the new mortgage rate is the ‘headroom’.
Chart 1: Average stress rate versus new mortgage rate
Sources: FCA Product Sales Data and Bank of England calculations.
Increases in mortgage rates since January 2022 mean that, on average, there is less ‘headroom’ between the rates borrowers were stressed at and the rates they faced when exiting their fixed deals. However, this ‘headroom’ has not been completely depleted. This suggests that ‘stress rates’ applied have been effective on average in testing that borrowers could afford the new higher rates they faced at the point of re-fixing. When borrowers re-fix without an increase in the underlying principal, they are not subject to a further affordability test.
At higher mortgage rates the ‘headroom’ is smaller (and vice versa). The new mortgage rate is based on the average two-year fixed rate, which during 2023 was higher than the average five-year fixed rate, meaning the ‘stress rate headroom’ would be higher if someone was taking out a five-year deal. If customers don’t re-fix they revert to lenders’ SVRs, which are higher than prevailing fixed term rates, meaning the ‘headroom’ would be lower.
Distribution of borrowers across stress rates
While on average we find a positive ‘headroom’, things could be different for individual borrowers. Chart 2 shows the distribution of fixed mortgages coming to the end of their term in 2023, grouped by stress rate and highlights the proportion (red bar) that were stressed below the average two-year fixed rate over 2023 (5.62%).
Chart 2: Stress rates for fixed-rate mortgages reaching maturity in 2023
Sources: FCA Product Sales Data and Bank of England calculations.
Note: The first bar captures all stress rates below the average two-year fixed mortgage rate over 2023 (5.62%). To coincide with the average mortgage rate, the second bar has a slightly higher range than other bars. The last bar captures all stress rates above 7.50%.
Our analysis suggests that, despite the significant increase in mortgage rates, only 4.30% of all fixed-rate mortgages reaching maturity in 2023 were tested at a stress rate lower than the average two-year fixed mortgage rate over 2023 (5.62%). The majority of borrowers would still have had some ‘headroom’ at mortgage rates of 6.50%, which was the highest point mortgage rates reached in 2023. As shown in Chart 2, stress rates for borrowers exiting their fixed-rate periods in 2023 are concentrated between 6.50% and 7.25%, so at mortgage rates above that level, the number of borrowers without the ‘headroom’ provided by the affordability test would have increased significantly.
Conclusion
The interest rate borrowers pay on their mortgage is a key element of affordability, albeit not the only one. In our analysis, we find that the ‘stress’ assessment carried out by lenders at origination will generally have subjected borrowers coming to the end of their fixed-rate terms in 2023 to higher stress rates than the prevailing mortgage rates when re-fixing.
The wider implications of our analysis on the housing market are hard to disentangle, given the multiple factors at play; one potential implication is that ‘stressing’ is likely to have helped limit any forced sales from affordability pressures. Overall, our post highlights the important and not widely acknowledged impact that ‘stressing’ may have had in supporting the resilience of individual borrowers and the overall market.
Daniel Norris, Elio Cucullo and Vasilis Jacovides work in the Bank’s Prudential Framework Division.
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You talk of mortgage providers stressing borrowers? How is this practically done – they have only a very partial look at mortgage holder’s financial situation.
The fact that this stress measurement resulted in a headroom greater than the observed change and yet the observed impact on finances looks severe suggests that the stress score in fact drastically over estimates the ability of mortgage holders to absorb a change in rates.
Stressing may have improved the situation but I’m not sure that it’s a reliable measure of the stress the system can actually endure.
Although the stress test is useful and will limit some exposure for banks, it doesn’t factor in the couple who have had a child in the last two years with another on the way, with one parent either reducing their work hours or paying exorbitant childcare fees whilst all of their bills and outgoings have gone up by ten or twenty percent along with the credit card bill they’ve racked up from maintaining the lifestyle they lived when spending their lockdown savings. Or to put it more simply – lots of people aren’t going to be able to afford their new mortgage for reasons over than just a higher rate. The authors do allude to that but the overall impression is that everything is going to be fine. Throw in a housing price correction that tips the people mortgage brokers swindled into borrowing the absolute maximum they could get into a new LTV category and an even higher rate than they were expecting and there’s potential for a much more dramatic outcome. Throw in an oil tanker being sunk or Israel doing something really extreme that pumps inflation again and the stress test will look as useful as not ever having had one.
Great article. Resilience of the market point is particularly interesting. I suspect commentary on falling house prices / a market crash over recent months didn’t pay enough attention to the stress testing baked in to the mortgage process after 2014. Anecdotally I understand that there’s little stock on the housing market presumably because there are few buyers due to cost of debt and few compelled sellers because of appropriate stress testing. Whilst this also underpins market resilience it makes it even more difficult for the first time buyers, and I suspect when rates start to fall competition will be fierce and this will positively impact price. This is a generation smashed by rising rents and desperate to get out of it after all
I initially couldn’t understand why the orange line in chart 1 didn’t maintain a similar spread against the new mortgage rate. But then I noticed the comment on no affordability requirements on remortgage is required so they remain largely unchanged. They do however seem to come in a bit as base rates rise, why is that? Presumably transaction numbers fell off a cliff as base rates rose which removes the smoothness of the line and stops it rising in line with base rates?