Higher mortgage rates in the UK have significantly weakened residential mortgage affordability across multiple segments, according to Fitch Ratings. 

The ratings company suggests 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 the UK residential mortgage backed securities (RMBS) prime and buy-to-let (BTL) asset performance outlooks to deteriorating from stable on 29 September. 

It expects the Bank of England policy rates to peak at 5.0% in Q2 next year, which sits slightly below the financial market expectations. 

Fixed mortgage interest rates have already increased from 5.5% to 6.0%. 

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 around 2.5% and a monthly instalment of £1,000 over a 25-year term. 

Fitch says if refinanced at 6.0%, the monthly instalment would increase to £1,450. 

Based on mortgage loans advanced in 2018, Fitch estimates that around £90bn (6%) of total outstanding mortgage debt of five-year fixed products are due for refinancing 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. 

Fitch notes that borrowers with a high LTI ratio are proportionally more exposed to rising interest rates. 

First-time-buyer (FTBs) and high loan-to-value (LTV) portfolios typically have the largest concentration of high LTI loans with around 15% of loans in such pools in Fitch-rated RMBS deals having 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 London interbank offered rate (Libor). 

Fitch says that 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.

This means by Q2 2023, it will have gone up by 188% 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, will face similar rises. 

Meanwhile, a BTL mortgage deal taken out in 2017 would on average have had an interest rate of 2.8%, an LTV of 70% and a gross rental yield of 6%. 

Fitch explains that 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. 

However, not all properties achieve the average rental yield. Fitch says 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%.