It’s long been common practice for the Federal Reserve to raise interest rates in order to keep the economy from heating up too quickly — hence the recent rise by a quarter point in December and projections for more gradual increases in 2019.
But a study by Bauer College Assistant Professor of Finance Kevin Roshak and doctoral students Don Carmichael and Dimuthu Ratnadiwakara raises questions about the cost of doing so.
“When someone buys a home and takes out a mortgage, the prevailing interest rate at the time of purchase can stick with the buyer for a long time,” Roshak said. “Most mortgages are fixed-rate, and it is costly to refinance into a new mortgage if rates drop.
“This became dramatically clear in the previous recession — mortgage rates were nearly halved, but it was difficult to refinance because home prices dropped 30 percent and many people were underwater or unemployed. Many borrowers had to keep paying a high interest rate on their mortgage.
“We wanted to know how past interest rates affected mortgage default and consumer spending.”
Analyzing mortgage data from Freddie Mac, the Bauer researchers found that a half-point increase in the prevailing rate at origination (which amounts to about $700 in extra payments per year for the typical borrower) leads to a 10 to 20 percent increase in mortgage delinquency for underwater borrowers, Roshak said.
“Further, the increase in rates appears to crowd out consumption of services and nondurables.”
“By locking borrowers into higher rates, a future recession can become more painful,” Roshak said. “Policymakers may want to use other regulatory tools first before raising rates.”
By Julie Bonnin