Higher mortgage rates in the UK have significantly weakened residential mortgage affordability across multiple segments, Fitch Ratings has warned.
It said that this will eventually increase arrears and defaults in securitised pools where borrowers pay floating interest rates or have to refinance at higher fixed rates.
Fitch revised its UK RMBS prime and buy-to-let (BTL) asset performance outlooks to deteriorating from stable on 29 September 2022.
Fitch expects Bank of England policy rates to peak at 5.0% in 2Q23, slightly below financial market expectations.
A representative borrower with a gross income of £50,000 entering into a mortgage at a loan-to-income (LTI) of 4.5x in 2017 would have obtained a rate of about 2.5% and a monthly instalment of £1,000 over a 25-year term. If refinanced at 6.0%, the monthly instalment would increase to £1,450.
Based on mortgage loans advanced in 2018 (when total gross lending was £218.8bn), Fitch estimates that about £90bn, or 6% of total outstanding mortgage debt, of 5-year fixed products are due for refinance in 2023. Wages have grown by an average of 22% since 2017 and no stress rate is required in affordability testing for five-year products, although UK bank regulation caps the proportion of mortgages advanced at an LTI above 4.5x at 15% of new lending.
The benefit to borrowers from the recently announced reductions in basic rate income tax and national insurance is minor compared with rising mortgage costs. The balance of increased interest costs will need to be met from changes to household consumption, which should be more manageable for higher income households.
Borrowers with a high LTI ratio are proportionally more exposed to rising interest rates. First-time-buyer and high loan-to-value (LTV) portfolios typically have the largest concentration of high LTI loans: about 15% of loans in such pools in Fitch-rated RMBS deals have an LTI of 4.5x or higher when weighted by balance.
In older pools of non-conforming mortgages borrowers are directly exposed to policy rate increases as payments are typically a margin above either the bank base rate or Libor.
For a representative non-conforming borrower with an interest-only mortgage at 2.5% above the base rate, payments have increased by 83% since November 2021 and will have gone up by 188% by 2Q23 if Fitch’s expectations of UK policy rate increases are borne out. ‘Mortgage prisoners’, whose lenders no longer offer new products and who cannot refinance elsewhere due to their financial circumstances, face similar rises. These borrowers usually pay their lender’s standard variable rate, giving the lender some discretion over how far policy rate increases are passed through.
BTL affordability is assessed using the interest coverage ratio (ICR) from rental income. A BTL mortgage entered into in 2017 would on average have had an interest rate of 2.8%, an LTV of 70% and gross rental yield of 6%.
This gives an ICR of 3.1x, well above the usual minimum of 1.25x for limited companies and basic-rate taxpayers or 1.4x for higher-rate taxpayers. Refinancing this mortgage at 6.0% and accounting for 2.3% annual growth in rents reduces the ICR to 1.6x.
But not all properties achieve the average rental yield. A yield below 5.25% would require the borrower to reduce the LTV below 70% to pass the affordability test. In a typical recently originated Fitch-rated BTL pool, about a quarter of the collateral had a yield below 5.25% and LTVs above 70%.
