3 C’s of mortgage lending | Lesson 1 Capacity
My very first full time job out of college, was at Cheltenham & Gloucester, in 1999, based on the cross road on High Holborn, WC1 (now the TSB branch on the same spot, as C&G was swallowed up by LloydsTSB, and then LloydsTSB split up to Lloyds and TSB years later).
This is relevant as it was a very old school set up. Mortgage applications were underwritten, processed and then sanctioned all from that office.
The managers have differing levels of underwriting mandate (so a Junior Manager could sign off mortgages up to £250,000, a senior Manager up to £500,000 and the Branch Manager well over £1m) with only very large, complex or risky loans having to go to the Head Office in Gloucester for final sign off.
This set up even then was unusual, but today it is a thing for the history books.
However, it gave you a really great understanding of how and why mortgages were granted (except for the age old trick of a broker taking a manager out for a boozy lunch to get stuff agreed… ah the old days… I never saw that happen of course, just heard old wives tales of such things…).
The principles of mortgage lending
So in a series of blogs I am going to go over one of my first, and core lessons on mortgage lending – The 3 C’s, which are:
Being the first in the series, I’ll start with the first aspect – Capacity.
Mortgage lending capacity
Mortgage lending capacity in modern parlance would be – Affordability – Or in plain English – what can you afford?
This is a logical place to start when looking at a mortgage as it gives you context.
You want to borrow £500,000, great, how are you going to pay for that? If your earnings are £250,000, that’s a great start, as there is clearly a very large capacity for repayment there. If your income is £50,000 you are going to struggle, as the monthly payments are likely to be more than your take home pay each month.
Not a great start… so at a very high level, this sums up Capacity – what is the loan and crucially, the monthly payments, relative to your monthly income.
These days the FCA (as it was the FSA back then…) has much clearer guidance around what we call Affordability. Indeed it is so prescriptive that the Bank of England introduced a rule in June 2014 that mortgage lenders can not offer more than 15% of its new loans at more than 4.5 x a clients income.
From that day forward, that became the standardised norm. So when clients ask us how much can I borrow, our stock response is – about 4.5 x your income. That said, this is where it gets interesting (or as interesting as a blog on mortgages can get…) as what is deemed as income, and what are the exceptions?
What is the mortgage multiple?
Again, very general rule – the more you earn, the more you can borrow. Not in a linear sense as 4.5 x £250k is clearly more than 4.5 x £50k, but in a proportional sense.
If you reverse that rule from the Bank of England – Lenders can offer up to 15% of its new mortgage lending to more than 4.5 x income for certain clients – so again, another industry standard started to come about, which is – if you earn around £100k you can get a great multiple of your earnings.
At the time of writing, a few lenders are currently offering 5.5 x income for these clients which is a significant boost to the mortgage on offer. Why? Well, once you clear your utility bills, food, etc these are broadly the same for everyone, and a much lower % of take home pay for higher earners.
So going back to that C word above, higher earners simply have a greater capacity to repay mortgages from their disposable income.
Tarquin’s straw boater for school obviously does not come for free, but that is classified as an discretionary spending. So if you do have extra costs like private school fees, lavish holidays, large fixed savings/pension payments per month etc, these are optional extra’s that could be reigned in should they need to be, so are often completely ignored when looking to grant a mortgage.
On the flip side, what we call ‘committed expenditure’ is very much factored in. that will be things like credit card balances not repaid in full, loan repayments, Car HP, etc. Essentially anything that sits on your credit file as an outstanding commitment.
So picking the higher earner in the example above, great starting point that you earn £250,000 a year, but if you have a £700 a month payment on the Disco (Range Rover Discovery for non-car fans), £10,000 on the credit card from a trip to the US (remember those days..), and a £900 a month loan for an extension to the house that you did, you quickly eat into your capacity for payment a new mortgage. (FYI, given the example above the loan would still be offered but you get the point).
How it works in simple terms is that lenders take the annual amount of your loan commitments (in the example above, that is £19,200 as £700 + £900 = £1,600, per month x 12), and 3% of any credit balances, then annualised again, and deducted from your salary (so again, as per above – £10,000 x 3% = £300. X 12 = £3,600, which is then deducted from your income). To complete the example, if your salary is £250,000 and you have £22,800 of annual credit commitments, lenders then work on an income of £227,200 before they assess how much you can borrow.
What is deemed as income?
Then that leads us into the very thorny issue of what income is taken into account. If you are employed, and been in your role a while, then that is quite simple. Mortgage Lenders will look at your basic salary, plus any bonus or commission.
On the ‘variable’ income, so your bonuses or commission etc, most lenders take an average of the last 2 years, add half of that to your basic, then apply the multiples above (so in a simple example, you could have a £50,000 basic, £10,000 bonus this year, and £8,000 last year. Lenders will take the average of the last 2 years – £9,000, then add half that figure to your basic salary = £4,500 + £50,000 = £54,500, then multiple by the relevant amount, less commitments as detailed above).
If you are self employed or have a complex income, or even a very high income (which is deemed to be over £300,000), life can get more complicated. So rather than a simple exercise like the above, we need to look at what your annual income is as deemed by accounts, tax return, accountants certificate.
Once we can ascertain what your income is, we can the apply the rules as outlined above. For a more detailed look at this, we do have pages and videos on our website for Self Employed and Large Loans, which will worth a watch/read if you want more detail on these more complex areas.
High Net worth individuals
Lastly, and more rarely these days, some lenders can take a different view if you have a very strong asset base. This is more common in the Private Banking world and helpfully the FCA have clarified what they deem a High Net Worth individual to be, which is someone who earns over £300k per year, or has £3m of net assets.
Now you don’t need to tick these boxes, but the general concept is the same.
Lets say you have £500,000 in cash, but want to buy at £900,000, to be near a great secondary school for your child for the next 5 years as you want to be in the catchment area but you have no income in a traditional sense. High Street lenders won’t entertain this but some smaller lenders, or specialist can look at this in the following way.
Why don’t you put down £400,000 as deposit, we’ll advance you the £500,000 you need to complete the purchase, but we’ll place £90,000 on escrow with us in order to cover the interest costs over the next 5 years. An Interest Only mortgage could be granted, at a rate of 4% or less, and you can cover the payments that way (500,000 at 4% = £20,000 pa x 5 = £90,000).
As I say, very few lenders do this now, but the principal around mortgage lending capacity, which is the point to the blog, is met. In fact you can argue this is the lowest risk loan of all the ones mentioned as the payments are guaranteed. A similar concept is seen in divorce cases where lenders can offer loans depending on the terms of any payments made to the divorcee. This is normally evidenced by Bank Statements or Court Order.
Importance of mortgage lending capacity
Believe it or not, this is barely touching the sides of one of the most important principles of mortgage lending. But hopefully this gives you can overview of mortgage lending capacity and a few key lessons which you can take away with you.
Again, going back to my early days at C&G, when we were assessing mortgages we would very often ask ourselves would you lend this person your own money? If the answer was yes, we’d try our hardest to find a way to agree the loan. If it failed that ‘gut check’, the next conversation was a polite ‘well, it’s been lovely talking to you, but on this occasion…’
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