Financial Conduct Authority Occasional Papers
November 15, 2015
The core element of the 2012 Mortgage Market Review (MMR) recommendations – the responsible lending rules – aimed to ensure that borrowers would in future only be able to take out ‘affordable’ mortgages. During the development of the new policy and to explore its likely impact, a method was needed to measure and judge mortgage affordability, using the data available at the time.
This paper presents research undertaken for the MMR into three potential mortgage affordability metrics. These were based on: the debt service ratio (DSR), an expenditure-adjusted DSR and a quality of underwriting (QoU) score. The DSR measures evaluated affordability by looking at causal factors (household income, expenditure and mortgage characteristics), whereas the QoU score focused on mortgage outcomes (whether the borrower subsequently went into arrears or the home was repossessed).
This report sets out the theoretical and practical advantages and limitations of these approaches. To assess the impacts of the proposed affordability rules, we also developed a methodology for exploring changes in the well-being of borrowers. This enabled us to compare the gains in well-being when borrowers were stopped from taking out unaffordable loans, with the loss in well-being caused if the same rules blocked mortgages that in reality would not have become impaired.
For the MMR analysis, given data constraints at the time, a hybrid affordability metric was preferred, based on the QoU methodology but also using the DSR. An important finding, however, was that the expenditure-adjusted DSR is likely to offer the most valuable method for informing future mortgage policy development, as improved expenditure data becomes available in 2015.
Overall, it is hoped that the methodological insights offered here will be valuable to other researchers working in the highly topical area of mortgage affordability.