De-stressed lending

Against the backdrop of tightening lending regulations, clients looking to borrow funds may be surprised to learn that the recent comprehensive reform of the mortgage market hasn't reduced private banks' appetite to lend. Indeed, the impact of the review has, in some cases, been to loosen banks' lending criteria rather than squeeze them.

Tightening the regulations over lending is one of the main ways policymakers hope to dampen the fervour in UK house prices. These have been rising at a double-digit annual percentage pace and are causing concerns about a potential property bubble.

The Financial Conduct Authority (FCA) felt at the height of the mortgage market in 2007 that while the market had worked well for many people, it had caused severe hardship for others. It believed that the regulatory framework then in place was ineffective at constraining high-risk lending.

The resulting Mortgage Market Review (MMR) - a comprehensive evaluation of the mortgage market - started in 2009 and culminated in new rules in October 2012, most of which came into effect on 26 April 2014. As such, it is not to be seen as a knee-jerk reaction to current fears of an emergent "housing bubble". The MMR reforms aim to ensure continued access to mortgages for the vast majority of customers who can afford them, while preventing the poor practices and excessive lending seen in the past.

A key outcome of the review is that lenders are now fully responsible for assessing whether customers can afford their loans, and have to verify their customers' income. They can still involve intermediaries in the process, but the lenders will remain responsible.

Borrowers will have to undergo a series of checks to assess their ability to afford repayments. This includes an assessment of all committed expenditure and outgoings, such as the cost of servicing and repaying existing debt, and basic essential expenditure, e.g. utilities, childcare, food and travel.

Stress test

Lenders have also been asked to 'stress test' borrowers' ability to afford repayments should UK interest rates rise, which we expect them to do gradually by next year. Most banks - private and retail - already apply such tests in assessing affordability, although without clear guidance on what sensitivity rates to apply.

The MMR has provided some methodology to allow banks to calculate the appropriate stress test depending on the product sought. In some circumstances, this has meant lower stress-tested rates than in the pre-MMR world. In such cases, the new rules increase affordability for clients and inject additional confidence into lenders' credit stress models.

Interestingly, the MMR guidance doesn't cap the loan-to-value or multiple of income that people can borrow, although the Bank of England's independent financial policy committee (FPC) subsequently specified limits when it also put in place policies (under consultation until August) to curb risky mortgage lending. For instance, the FPC recommends that mortgage lenders limit the number of mortgage loans made at or greater than 4.5 times loan-to-income to no more than 15 per cent of their overall number of mortgage loans.

Interest-only flexibility

The MMR also stipulates that borrowers seeking interest-only mortgages must be able to demonstrate a credible repayment strategy, which cannot be based solely on predicted rises in property prices. While the market in interest-only mortgages has shrunk dramatically in recent years, the flexibility offered by such borrowing remains very popular with our clients. Many earn high incomes, but not necessarily through a high salary, with other income received, for example, from partnership distributions, bonuses, investment income or pensions.

Interest-only borrowing also allows greater flexibility around loan-to-value criteria. For example, it may be possible to provide an interest-only loan above the normal loan-to-value criteria and build in a series of formalised repayments (which can be timed to coincide with lump-sum receipts) that bring the loan back within parameters for an agreed time.

Tax-efficient borrowing

The continued availability of borrowing is important for many clients because of the benefits it can provide, such as tax efficiency. If borrowing is taken out to buy, or release equity from, a rental property, it's usually possible to claim a deduction against UK rental income equal to the interest paid on the borrowings. The costs of arranging finance may also be deducted.

The maximum debt value on which the interest deduction is available is the market value of the property when it was purchased, or when it was introduced to letting, if later. The loan doesn't have to be secured on the rental property to qualify although interest must be paid and not rolled up.

Mortgage approvals will take longer as a result of the stricter assessments and lengthier advisory process. British Banking Association data shows that mortgage approvals declined in May for the fourth month in a row. However, most lenders - certainly private banks - have already been applying the new guidelines without any appreciable impact on lending.

Kumar Jethwa is a private banker, professionals client group, at Coutts

Coutts writes a regular blog for Private Client Adviser

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