Income Multiples: Mortgage Affordability

May people ask how lenders determine how much they will lend to them. This used to be relatively simple to determine but these days lenders are becoming much more sophisticated in the way they work out how much they will lend. Furthermore, this is likely to become even more sophisticated as the Financial Services Authority brings in new rules that put a lot of responsibility on the lender to make sure their borrowers can afford their mortgages.

 The old way to work out a loan was to simply multiply a person's income by 3. For example, take gross salary, deduct payments to loans to arrive at a 'net' figure - multiply this by 3.

Jack earns £20,000pa and pays £250pm to a personal loan. Annual loan payments are £3,000 (12x£250) deduct this from annual salary of £25,000 to get a net figure of £22,000. The maximum loan would be £66,000 (3x£22,000).

The method described above worked well for many years but it didn't take into account interest rates. For example, 4 x income might be affordable for interest rates at 5%pa but may not be affordable if interest rates were to increase to 7%.

Due to certain fixed costs of living (heat, fuel, food, clothes) a person earning £10,000 a year may have less spare money than a person earning £50,000pa - is it right that both these people should be restricted to a fixed multiple of their earnings? The person earning £10kpa is less likely to be able to afford a mortgage of £40,000 than a person earning £50,000pa could afford a mortgage of £200,000.

To a certain extent some lenders recognised this and decided to allow higher income multiples for people earning higher salaries. A few lenders also take into account expenses like council tax, insurances in addition to credit commitments to arrive at an affordable level of lending. Again, this works quite well but the FSA wants to go a step further. In the future it is likely that all mortgage applicants will have to complete a stringent affordability test; they may be required to provide finite details of their living expenses to determine exactly how much disposable income they have. Furthermore, the lender may be required to apply affordability to interest rates higher than at the time the mortgage is applied for - this is to allow for future interest rate rises.