Before your bank hands over thousands of pounds for you to buy a home, you must prove you can afford to pay it back.
Your monthly mortgage payment is likely to be your biggest financial commitment, and the one which carries the most severe consequences should you fall behind on repayments.
That’s why banks and building societies rigorously check your mortgage affordability and ask for proof of your earnings and outgoings when you apply.
Being able to comfortably repay your mortgage each month, alongside any other debts you have, your household bills and living expenses means your home loan is affordable.
‘Comfortably’ is key. After all your outgoings have been added up and subtracted from the money you earn you still need to have cash left over to act as a buffer in case unexpected bills arise.
Mortgage affordability is important for two reasons. If you fall behind on your payments it will be recorded on your credit report and linger for six years. This will drastically reduce your credit score affecting your chances of getting a mortgage, loan or even phone contract in the future. If you can’t meet your minimum contractual payment, or stick to an arrangement your lender has put in place to help you, ultimately your home will be repossessed and sold to repay your debt.
It’s sounds scary, but in reality repossession is rare. Banks and building societies have a duty to lend responsibly, under rules put in place by watchdog the Financial Conduct Authority.
This means you’re protected from taking out too much mortgage finance by what’s known as an affordability check.
Lenders use a number of ways to check your affordability so let’s look at each one individually.
To work out the maximum mortgage a lender will offer you, banks and building societies use what’s called income multiples.
Let’s say you earn £30,000 a year before tax. A lender using an income multiple of 3.5 would multiple your £30,000 salary by 3.5 to get £105,000. Obviously, if you’re buying with someone else you add your salaries together and then apply the lender’s multiplier.
A common income multiplier for first-time buyers is 4.5 times earnings, giving a single person on a salary of £30,000 a maximum mortgage offer of £135,000. A couple with joint income of £60,000 would be offered £270,000.
Most of the high street lenders will agree a mortgage that is 5.5 times a borrower’s salary if they have a deposit of between 15% to 25% and earn at least £75,000. Nationwide’s first-time buyer deal, ‘Helping Hand’ only requires a 10% deposit and borrowers can earn £31,000 or more.
Some small building societies, such as Darlington Building Society, offer mortgages that are six times the value of the borrower’s salary if they have a professional career.
Once the maximum value of your mortgage has been worked out, the lender will check you can afford to pay it from your monthly earnings after tax after you’ve paid all your other bills and deducted daily living expenses too.
Commonly accepted types of income include; basic employed and self-employed earnings, benefits such as child and working tax credit, pension, rent from a buy-to-let property. Although you can boost your earnings by using bonus pay, overtime and commission, because this income can go up and down, lenders often restrict the amount you can use.
When adding up your outgoings you’ll need to include; all your regular bills such as council tax, utilities and phone contracts, any monthly debt repayments, transport costs, childcare, school fees, food shopping and money spent on socialising, holidays and hobbies.
Once you’ve subtracted all your outgoings from your income you need to have enough left over to afford your mortgage payment with a buffer.
A mortgage lender’s stress test is not a test to see how well you cope under pressure. It’s a test to see if you could afford to repay your mortgage if interest rates rose by 3%. When you’ve completed your income and outgoings assessment, the spare cash you have left over must be enough to pay for a mortgage that has an interest rate 3% higher than your lender’s standard variable rate.
The average standard variable rate is 4.41% which means you must be able to afford an interest rate of 7.41% to be approved. Sounds steep, but it means there’s plenty of room in your budget should interest rates rise in the future. One way to avoid the harsh stress test is to opt for a five-year fixed rate. Some lenders do not stress test to such a high level if you fix your rate for five years or longer, as it is seen to reduce the risk for the borrower.
Okay, you’ve got your maximum mortgage offer, you’ve worked out that you have enough money left over after your bills and expenses have been paid to afford a rate of more than 7%, you have just one more hurdle to clear. Achieving a low debt to income ratio.
Working out your debt-to-income (DTI) ratio is easy. Take the total debt you have on credit cards, divide that by your annual salary and multiply by 100.
But what does this mean? Well, as a rule of thumb to be accepted by almost all lenders you would need to have a DTI of 30% or less. Up to 40% and you may not be offered the highest income multipliers available. With a DTI of 50% or more, lenders consider you to be a high-risk borrower. You would have a limited choice of lenders offering mortgage deals at high interest rates and your credit score and history would need to be tip top.
Lenders will also take into account the level of monthly debt payments as part of their affordability checks
If your salaries are falling short of the mark, a mortgage called ‘joint borrower sole proprietor’ could help. This type of mortgage gives you an income boost by allowing you to add family members or helpful friends to your application giving you a greater combined salary to increase your mortgage offer. They are not added to the title deeds so you remain the sole owner.
If you’re bamboozled, still wondering “how much mortgage can I afford?” you can use an online mortgage affordability calculator to give you a rough idea of the value of the mortgage you’ll be offered. You can check out Tembo’s mortgage calculator here, or try Moneyhelper.org.uk, the government’s money advice service.
Words by Samantha Partington