A stable, well-functioning financial market for allA stable, well-functioning financial market for allFI Analysis 9: Households’ interest rate adjustment periods – an economic vulnerability?
SUMMARY: In Sweden, both the percentage of mortgages that have a variable interest rate and household debts have risen sharply. This combination has made house-holds sensitive to rising interest rates.
On the one hand, high interest rate sensitivity helps stabilise consumption since interest rates and income normally shadow one another. Interest rate sensitivity also presents good conditions for monetary policy to stabilize the economy. On the other hand, high interest rate sensitivity could mean that households would be particularly hard-hit if interest rates rose without a parallel increase in income. Households would then be forced to lower their consumption and, in a worst-case scenario, find it difficult to repay their debts.
Our analysis shows that the margins of new mortgage holders have increased over the past few years. Despite shorter interest rate adjustment periods, the ability of households to repay their debts does not appear to be impaired by short-term upswings in interest rates. However, the large volume of liabilities subject to variable rates is still cause for concern. If interest rates rise while income growth is low, households may be forced to reduce their consumption. It can be noted, though, that an analysis of historical outcomes in several countries shows that the probability that this scenario will occur is low.
Regardless of the effects on the macroeconomy, high sensitivity to interest rates could introduce risks from a consumer protection perspective. House-holds facing low margins, high debt-to-income ratios or a risk that they may lose their income are particularly vulnerable to higher interest rates. By fixing their interest rates, these households could protect themselves from interest rate risk and take advantage of the interest rate adjustment period to build resistance before their interest rate rises. The analysis shows that both vulnerable and resilient mortgage holders have chosen to have a high percentage of their loans at a variable rate. Instead of fixing the interest rate as a preventive measure, households have increasingly borrowed more at variable rates as the interest rates have fallen. As a result, households have become vulnerable to unexpected increases in the interest rate.
There are several reasons why individual households should be cautious and fix the interest rate for a large part of their mortgages in the future, First, the Swedish economy is currently experiencing a unique situation in that interest rates are very low at the same time as economic growth is strong. It is more likely that interest rates will rise in the future than fall. Second, a long interest rate adjustment period makes it possible for households with high debt-to-income ratios to build up resilience before the interest rate must be re-set. Third, an individual household's income can decrease or increase slowly even if the aggregate increase is high. The point in time that interest rates rise may also occur before individual households experience a rise in income.
It is important for households to be able to effectively manage their interest rate risk. This means understanding the consequences of fixing the interest rate, and banks play an important role in helping households understand the advantages of fixed rates. It is also important for households to be able to choose between variable and fixed interest rates without frictions that distort their options, but the analysis shows that the current regulations for early re-payment of mortgages can contribute to such frictions.
