The U.K. Bank of England base rate has been increasing steadily since December 2021, now standing at a 15-year high of 5.25%. Although mortgage rates have fallen in recent weeks, a higher for longer rate environment looks a realistic scenario. In this report, S&P Global Ratings takes a closer look at how owner-occupied borrowers backing U.K. prime residential mortgage-backed securities (RMBS) transactions who have faced payment shock have performed since their monthly payments have increased. We also assess the scale of reset risk that U.K. owner-occupied RMBS transactions face. Our analysis focused on a sample of prime owner-occupied mortgages totaling £28 billion backing 17 U.K. prime RMBS transactions (covering both S&P Global Ratings' rated and unrated deals). Our findings point to overall resilient collateral performance, with most borrowers able to refinance, and arrears greater than 30 days contained to only 2.2% of the borrowers who have not refinanced.

U.K. Mortgage Rates Are Falling, Yet Remain Volatile

Policymakers have not lowered the Bank of England base rate since it was increased in December 2021. Forward-looking market rates have been more volatile (see chart 1). Although interest rates have fallen recently, they remain high compared to the previous decade. A five-year fixed-rate mortgage would currently have a rate of approximately 5.9% (actual rates vary by credit quality and loan-to-value ratio), Moreover, we expect rates exceed those seen over the past decade, representing a paradigm shift for U.K. mortgage borrowers.

Chart 1

Performance Varies For Borrowers Exiting Fixed Rates

Chart 2 shows the performance of loans in our sample that suffered payment shock at some point between the end of Q3 2022 to the start of Q3 2023, relative to the performance of borrowers who remained on a fixed rate throughout the same period or were already on a variable rate. The chart measures the current balance of loans in arrears as a percentage of the overall balance for that cohort. Of the £2.9 billion of collateral that exited a fixed rate between the end of Q3 2022 and the start of Q3 2023, approximately 89% of loans have refinanced outside the pools in our analysis. As some collateral in the sample analyzed was already on a floating rate, the proportion of loans that exited a fixed rate in the period analyzed will vary by transaction. Of the borrowers who have exited their fixed rate and have not refinanced outside of the analyzed pools, 2.22% are in arrears of greater than 30 days. We estimate that 0.75% of the 2.22% was in 30 or more days in arears in Q3 2022. Although this arrears level exceeds that of those observed in the in the wider borrower population, it is to be expected given the selection bias toward loans that have not refinanced. It is difficult to predict absolute levels of arrears--also considering arrears are calculated as total delinquent amounts divided by the monthly installment--a rising rate environment can lower reported arrears compared to a flat interest rate scenario. Likewise, the opposite is true, if rate and monthly payments fall, increases in monthly arrears may be recorded. However, we currently expect prime U.K. mortgage delinquencies to remain within 2%.

Although it is possible loans in arrears were repurchased from the underlying transactions, broadly flat arrears reported in the wider mortgage market would support the view that most borrowers who exited transactions did so to refinance. It should be noted that the U.K. government's Mortgage Charter allows borrowers to refix with the same lender without additional affordability checks, although this would not have been the case in late 2022 and early 2023. Borrowers who exited to another lender will have had to pass a new affordability check. The nature of U.K. RMBS reporting means it is not possible to know who refinanced with the same lender and who refinanced to a new lender. So, it is possible that some borrowers who are suffering payment shock fell into arrears after refinancing with their existing lender. The degree to which transactions allow borrowers who refix to be retained in a transaction, so called "product switches" differs (see "How Do Product Switches Affect U.K. RMBS?"). However, if product switches are not permitted under transaction documents, lenders will likely continue to repurchase product switches from pools.

It should not, however, be assumed that the 11% of borrowers who have not refinanced necessarily have some credit impediment to doing so. Anecdotally, some borrowers are adopting a "wait and see" approach to rate volatility and are hoping rates fall before refixing, separately, some borrowers in the sample will be in the process of refinancing.

Chart 2

What Does This Mean For Future Mortgage Performance?

The outcome of the Mortgage Market Review introduced more prescriptive rules for how lenders need to demonstrate that loans they advance are affordable. This involves an assessment of borrower income and expenditure. Although the rules introduced in 2014 are more prescriptive than predecessor rules, elements of judgment remain for lenders when assessing income and borrower expenditure. For example, regulations are not prescriptive on how variable bonuses or sale commission are assessed. Lenders are also required to assess how borrowers will cope with rising interest rates. From 2014 until August 2022 lenders were forced to assess borrowers in one of two ways. Firstly, for anyone taking out a loan with a variable rate or a fixed rate shorter than five years, borrowers were assessed at 3% above the 'revert' rate (the rate a borrower will pay at the end of any fixed rate or discount period). For many prime lenders, the revert rate was their own standard variable rate (SVR). SVRs tend to fluctuate in lockstep with base rate movements. SVRs differ by lender but in the decade before 2022 had generally been in the 3.5%-5.0% range. This is significant as it means that the majority of borrowers will have been assessed for affordability at origination using a rate in the range of 6.5%-8.0%.

Anyone taking out a fixed-rate mortgage fixed for five years or more would be assessed at the five-year fixed rate. This rate was almost always lower than the prevailing rate plus 3% and, so, as an affordability test was a lower bar. Although not required to do so, many U.K. lenders would have used the SVR plus 3% approach even if the borrower was taking out a five-year fixed rate. So, although some borrowers in the five-year fixed-rate cohort have used the product to maximise leverage, not all have. Of the 2.22% of borrowers who exited a fixed rate and are in arrears, 1.66% of loans (75% on a relative basis) were originated as a five-year fixed mortgage.

In August 2022 U.K. regulators removed the 3% above the revert rate test. Initially lenders did not rush to utilize this relaxation in regulation. However, recently some lenders have been lowering this stress to 1% or 2% given that the top of the interest rate cycle is approaching. Moreover, the so-called "flow test" limits the proportion of new lending above 4.5 times loan-to-income to 15% of a lender's new originations.

Many borrowers will feel higher monthly payment pain

Our analysis of borrower payments indicates that because most borrowers took out fixed-rate mortgages at market rates significantly below current mortgage rates, borrower mortgage payments are likely to significantly increase (see chart 3). However, assuming rates remain around current levels, the scale of future payment shock will be in line with what we have witnessed over the past year.

The resilient performance of prime U.K. owner-occupied mortgages, can be attributed in part to the affordability measures highlighted above, but also to savings accumulated during the COVID-19 pandemic. Data that demonstrate saving rates by income levels is not available. However, the Bank of England estimated in its February 2021 Monetary Policy Report that the stock of excess savings was £125 billion and, with middle and higher income borrowers likely to account for most of this growth. Given deposit and affordability assessment requirements, it's likely that the majority of borrowers taking out recently originated owner-occupied mortgages are middle or higher income.

Chart 3

Strong wage growth will help, but beware of averages

Chart 4 shows the proportion of borrowers paying more than 40% of their income on mortgage payments increases to 5.7% from 1.4% assuming a payment rate of 6% after taking into account estimated wage inflation.

Although U.K. wage growth averaged 7.9% in September 2023, the average potentially flatters the real situation. Any residential mortgage underwriting decision is a point in time analysis. Income and expenditure of obligors can change significantly post-underwriting and not all borrowers will benefit from the average increase in incomes.

Some borrowers will receive pay awards above the average, while others will receive pay rises below the average. Those that receive more than the average do not subsidize those that receive lower pay rises.

Chart 4

Payment shock timing may also provide some protection

The majority of loans in the sample revert to a floating rate in the next two years, which gives borrowers some time to adapt to the new reality and the passage of time will also mean that borrowers benefit from wage growth. However, given the relatively high concentration, the performance of how loans that roll off in 2024 and 2025 should remain in focus.

Chart 5

Prime Collateral Performance Is Likely To Be Resilient Despite Continuing Payment Shock

As the vast majority of recent mortgage production is a repayment mortgage, requiring the borrower to pay off all capital by a maturity date, changing the maturity date, or moving to an interest-only basis can, all things being equal lower the monthly installment. However, rising rates mean that such tactics are likely to have a limited impact in lowering the monthly payment. Chart 6 shows that extending the term of the loan by five years at an assumed new pay rate of 6% would still result in a net increase in payment. Switching to an interest-only payment lowers the monthly payment to something approximating the current payment (see chart 7). While such a strategy is potentially viable for some borrowers in the short term, stringent underwriting standards which means lenders must robustly assess the viability of a payment vehicle mean that interest-only as a means of relieving payment shock is likely to be a rare exception rather than a rule.

Although changing mortgage terms will offer little respite for borrowers, we anticipate that relatively good affordability assessments and a strong employment market, combined with borrowers entering this period of turbulence with high savings rates, will support resilient performance. That said, we expect arrears to increase over 2024 as borrowers who do not benefit from high savings or wage inflation struggle to come to terms with their new reality.

Chart 6

Chart 7

What about nonconforming owner-occupied mortgages?

We performed a similar analysis on recently originated nonconforming transactions, not included in this report given the small sample size (six transactions, approximately £1.8 billion in collateral). Overall trends for recently originated nonconforming borrowers are in line with those we observed for prime transactions. Chart 8 shows the roll of of fixed-rate loans for nonconforming borrowers which shows a similar concentration within the next two years.

Chart 8

Related Research

• How Do Product Switches Affect U.K. RMBS?, Oct. 30, 2023
• U.K. Residential Mortgage Servicing Flexibility Could Ease Arrears Pain, April 26, 2023
• Cost Of Living Crisis: U.K. RMBS 2.0 Has Built-In Resilience, Sept. 6, 2022
• EMEA Structured Finance Chart Book, published monthly