Successive hikes in a whirlwind period for the UK economy and financial markets have taken it to its highest level since 2008 during the global financial crisis.
Markets are still trying to get to grips with this new higher interest rate environment.
The natural reaction is to batten down the hatches and to become more cautious.
But thankfully, we have rules and regulations designed to protect the market in scenarios exactly like this.
In 2015-16, during a period of relative economic stability, the Prudential Regulation Authority (PRA) introduced tougher underwriting standards (SS13/16) to ensure buy-to-let lenders lent responsibly and to protect landlords from over stretching themselves.
The new rules stipulated that lenders must have a rental income (ICR) of either 125% or 145% to cover for unexpected costs, such as repairs, non payment of rent and service charges.
The second requirement was for lenders to ‘stress test’ all applications to safeguard borrowers in case of a rise in interest rates.
At the time, two and three product rates were very popular and the PRA recognised that landlords on shorter terms were at high risk from sharp increases.
Although their rents may increase over a 24 or 36 month period, they wouldn’t withstand significant hikes in Base Rate. So, the PRA called on lenders to ensure that borrowers would be able to cope with interest rates of at least 5.5%, or the product price plus 2%, whichever figure was greater.
The measures were introduced to protect both lenders and borrowers from a market shock.
Although stress rates have superseded 5.5% today, the latter test, product price plus 2% still provides a suitable safety net for lenders and borrowers. For example, a lender currently offering a price of 4.9% should stress test by 125% ICR with a worst case scenario of rates going up by another 2% in two years, namely 6.9%.
This is more than enough to ensure both parties are not going to be in a precarious position, particularly as we know now, that the Base Rate isn’t on the trajectory that was first feared when financial markets began to wobble.
We should note that five year or longer fixed rates are tested in a more benign manner by stressing on the product rate. This recognises that the longer term of the fix provides not only protection to the borrower and lender but also most likely ‘’sees out’’ the volatility period.
But there’s a problem. Some lenders aren’t following the rules as set out by the PRA and this is unhelpful not to only the market but creates broker and landlord confusion.
What’s happening, is that they’re stress testing beyond the requirements, which as I’ve pointed out, are more than sufficient.
That risks damaging a market which is already absorbing recent external factors. We all know landlords have been hit hard by increased taxation in recent years, while affordability is also becoming more of an issue.
To protect the rental sector, lenders must not overreact and stop overcompensating by stress testing beyond appropriate levels.
Keep calm and carry on has to be the message, otherwise we only create more problems.
David Whittaker, CEO of Keystone Property Finance
