We outline the flexibility for firms in our interest rate ‘stress test’ rule and considering the effect of future rate rises on mortgage affordability.
Lenders must take account of the impact of likely future interest rates rises on a customer’s mortgage payments (the so-called ‘stress test’) when determining affordability.
Firms have flexibility to design their test in a way that is appropriate for the customer's mortgage. Many firms add a margin to the lender’s current reversion rate. With interest rates currently falling this may be unnecessarily restricting access to otherwise affordable mortgages.
This information reiterates the flexibility the rule provides.
Flexibility within the interest rate stress test rule
MCOB 11.6.18R[1] requires lenders to take into account the impact of likely future interest rate increases on affordability for a minimum of 5 years. The exceptions are where the contract is less than 5 years in length, in which case the lender must consider the impact of likely interest rate rises for the duration of the contract, or where the interest rate of the contract is fixed for the initial 5 years or more, in which case no stress test is required.
In coming to a view on likely future interest rates, firms must have regard to market expectations and any prevailing Financial Policy Committee (FPC) recommendation (the previous FPC recommendation was withdrawn in August 2022[2] so there is currently no prevailing FPC recommendation).
Firms set their own basis for considering the impact of future interest rates when assessing the affordability of a mortgage within the framework set out in MCOB 11.6.18R. This approach gives lenders flexibility to set the rate used in a way that reflects their customer base and products. This allows them to retain control and plan while testing the impact of interest rate rises on affordability for each mortgage application. Firms should not use their own forecast of interest rates, but may use their own models, provided they can justify them by reference to some independent forecast of market expectations.
Assessments can be adapted to different market conditions. For example, firms can have a different approach in a rising interest rate environment as opposed to when rates are falling.
Interest rate margins on mortgage products can change over the economic cycle, which may influence the margins lenders use to test affordability against interest rate rises. We would therefore expect the stress test to be compatible with and not mechanically linked to market expectations.
MCOB 11.6.18R does not prescribe which rate(s) a lender should take account of when designing a stress test (eg the initial rate, a firm’s reversion rate or a likely follow-on rate). We expect firms to apply an appropriate approach, considering the impact of expected interest rates on the customer’s ability to make payments.
Applying the stress test to a reversion rate
Many firms currently stress test affordability by adding a margin to their current reversion rate.
However, where a lender’s reversion rate does not take account of future market expectations this can result in an unnecessarily high stress test which may restrict some consumers from getting an otherwise affordable mortgage.
Alternative approaches to stress-testing
Different approaches can meet our requirements. For example, some firms do not link their stress test directly to a reversion rate.
We previously said[2] that when designing their stress test, lenders should take into account the variable interest rates that would take effect during the first 5 years of the mortgage contract. This includes reversion rates, if applicable.
This means when considering the effect of future interest rate rises within the first 5 years of a mortgage contract, if the customer is expected to revert to a reversion rate during that period, then the expected future rate should be factored into the consideration of the affordability of that mortgage.
For example, where a lender does not offer product transfers and the customer is on an initial rate, then the customer will move onto a reversion rate at the end of the deal and the expected future rate with that lender should be taken into account.
Alternatively, where a lender offers product transfers (eg most lenders are signed up to the industry voluntary agreement[3]) then the customer is likely to be offered a new deal from that lender. The lender may take account of the likely future rate that will be offered by the lender when assessing affordability in the light of future interest rate increases.
Mortgage Rule Review
We are carrying out a review of our mortgage rules, including our responsible lending rules. MCOB 11.6.18R is being evaluated as part of this review. We will shortly issue a call for evidence on the impact of this rule.
Fair value assessments
In designing its reversion product, firms are reminded that the Consumer Duty requires firms to deliver good outcomes for customers including ensuring that products provide fair value.
Firms should take into account the overall price of a mortgage including any initial discounted rate, fees and charges and the reversion rate applicable at the end of a fixed-rate period.
Firms should ensure fair value assessments remain valid for a reasonably foreseeable period and review them regularly (PRIN 2A.4[4]).
