An increase in mortgage rates may negatively affect house prices but will not necessarily hurt the economy. In actuality, an increase in mortgage rates could be beneficial, channeling funds to more productive uses.
How Is This Article Useful to Practitioners?
An increase in interest rates harms house prices and mortgage refinancing businesses, but the impact on the economy may be less damaging than assumed. Tax deductions for mortgages, tax breaks for property holdings, and implicit subsidies to state-backed mortgage lenders have resulted in artificially high US house prices. Since the financial crisis, interest rates have been kept low to revive the housing market. The idea is that if house prices rise, people will feel wealthier and more inclined to spend. This “wealth effect” results in increased demand and, in turn, instills confidence in firms to invest and hire staff. The underlying assumption is that an increase in mortgage lending is directly related to the efficient channeling of resources from banks to their clients. But consideration has to be given to whether the devotion of more scarce resources to the property lending part of the business is beneficial for the economy as a whole.
Diverting capital to mortgage lending has a negative impact on the ability of the corporate sector to attract funds and thus their ability to invest. This scenario is even more pressing for small and medium enterprises that are solely reliant on banks for financing. Thus, policies that encourage property lending do so at the expense of other potentially more beneficial investments. Not only do these policies have a negative impact on the economy, but they are also likely to harm banks’ future profitability.
The article highlights an interesting point that will resonate with many practitioners. Channeling the vast majority of capital resources into one area goes against the best practices of optimal capital allocation and may have other unintended consequences, such as the buildup of an asset bubble or the diversion of resources from higher-yielding investments.