How do lenders calculate the amount you can borrow? And what can you do to prepare?

One of the first steps in securing a mortgage is an affordability assessment. Mortgages are risky both for you and your lender, so your lender will want to make sure you have the means to make repayments for the duration of the term.

But affordability assessments are also important for another reason: they determine how much you can borrow. In turn, this has a huge bearing on what kind of property you can afford to buy.

In this article, we explain how affordability assessments work and discuss some strategies you can use to set yourself up for success.

Understanding affordability assessments

In the past, lenders determined affordability simply by looking at your income. You could expect to borrow an amount equivalent to between three and five times your annual income. The method changed radically in 2014, when the Financial Services Authority (now called Financial Conduct Authority), published the Mortgage Market Review.

It used to be easier to get a mortgage

Prior to 2007, getting a mortgage was much easier than it is today.

House prices were rising steadily, so many lenders were happy to approve mortgages even to borrowers who were likelier to default. The reasoning was that, worst case scenario, the housing market was so good they could still recoup the loan and make a profit.

Unfortunately, the market crashed in 2007, which led to the biggest financial crisis in decades. Affordability checks are now much tighter.

As a result of the Mortgage Market Review, lenders can no longer just look at your income. They must also look at your expenses.

How do affordability assessments work?

An affordability assessment consists of two parts.

Firstly, the lender will check how much money you make each year. Your main source of income is probably your full-time job, so your lender will need to see payslips (usually three month’s worth) and your P60 form.

Other income may also count, provided you can back it up with documentary evidence. This includes benefits and extra income from a part time job.

Secondly, your lender will want to know what your expenses are. These are deducted from your income. The aim of this exercise is to find out if your outgoings are such that the monthly mortgage repayment would cause financial hardship.

You can expect to be asked questions about:

your credit card debt

any outstanding loans

child and spousal maintenance

school fees

travel expenses

bills, including Council Tax, utilities, mobile phone contracts and insurance

Your lender will also want to “stress test” your finances. In other words, they’ll want to find out what might happen should your circumstances change, for instance if you have a child or your mortgage repayment increases. This will involve looking at your current lifestyle - how much you spend on things such as entertainment, holidays and groceries - and calculating the possible financial impact of any changes.

Your credit history is important

A credit check (also known as a hard search) is part of your affordability assessment, too.

Your credit history (which is recorded in your credit report) shows how you’ve handled credit in the past. Lenders use this to determine how likely you are to mishandle your debts in the future. Check your credit score and report regularly to make sure it’s in good shape. If it isn’t, you should start taking steps to improve it.

What if I’m self-employed?

Affordability assessments are the same whether you’re employed or self-employed. However, if you’re self-employed proving your income will be a slightly different process.

As a self-employed person, you obviously can’t provide lenders with payslips. And your income probably fluctuates from month to month. There’s also the risk that your income could change dramatically overnight, for instance if you lose a big client. Consequently, you can expect the proof-of-income process to be more rigorous.

Typically, you’ll be expected to provide three years’ worth of tax returns and a copy of your accounts certified by a chartered accountant. The aim is to prove you have a solid track record, which means you’ll be able to meet your monthly repayments.

You may also be asked for a business plan; and to provide evidence that you have work booked for the coming months.

When is the best time to take out a mortgage?

Lenders may be reluctant to give you a mortgage if you’re older, especially if you’ll reach retirement age before the term expires. You’ll need to prove you’ll be able to meet your monthly repayments despite the change in your financial circumstances, for instance by providing evidence of investments or other savings.

I failed an affordability assessment. Now what?

First things first, while your lender may be unwilling to loan you the amount you’ve requested, they may still be able to offer a lower amount or a longer repayment term.

If this won’t cut it - for example, if the amount is too low - there are other steps you can take. In fact, it’s a good idea to take these measures before you even apply for a mortgage. That way, you’ll be in the best position to get a great deal.

Pay off your debts

Credit card debt and personal loans can have a huge impact on affordability, so clear as much as possible before you apply for a mortgage. Credit cards carry especially high interest rates; and the longer it takes to pay them off, the more expensive they are.

As a plus, keeping your credit utilisation low could help to improve your credit score, which in turn will help you chances at getting a better mortgage deal.

Take control of your spending

Reining in your spending hits two birds with one stone: it reduces your expenses and shows lenders you’re financially responsible. It also saves you money.

Cancel any services or subscriptions you don’t use. The gym you haven’t been to in months or that magazine you never read might seem like minor expenses, but you’d be surprised at how much it can all add up.

More importantly, consider whether you could reduce some of your regular expenses. Try looking for cheaper car insurance, or a better deal on your utilities.

Budget carefully

Making a budget helps you manage your money more effectively and keeps your bank balance in check. This shows prospective lenders you can live within your means.

In a nutshell:

Since 2014, affordability checks have become stricter. Your lender will decide how much to loan you by calculating not only your income, but also your expenses.

Affordability assessments are the same, whether you’re employed or self-employed. But if you’re self-employed you’ll need to prove your business is doing well enough that you can afford repayments in the long term.

Try to pay off as much of your debt as possible and rein in your spending before you apply for a mortgage. This will boost your chances of being able to borrow as much as you need.