In April 2022, as a result of the increase in inflation, the Bank of Israel began to raise the interest rate in the economy. Consequently, there has been a significant increase in mortgage payments for households in Israel. This increase, alongside the rise in prices , is increasing the financial burden on households and is raising the cost of living.
The public discourse surrounding the increase in the interest rate tends to focus on its influence on mortgage holders. A new study by the Taub Center sheds light on another issue that should not be ignored when examining the effect of higher interest rates. What price would households have paid if the Bank of Israel had not increased the interest rate as a way of reducing inflation? And more specifically, how much did households pay as a result of the interest rate hikes and how much did they save from the resulting reduction in inflation, with respect to both their monthly mortgage payment and overall expenditure?
Dr. Labib Shami, Ori Oberman, and Prof. Benjamin Bental of the Taub Center have conducted a combined study of the mortgage market in Israel and the effect of inflation and the interest rate on the economy.
The relationship between the interest rate, inflation, and household expenditure is not sufficiently clear to the Israeli public
The mortgage market in Israel offers a variety of financing tracks for the purchase of a home. The size of the loan is limited and is determined by the loan-to-value ratio of the property and the household’s debt-to-income ratio. The monthly payment on the loan, which is composed of principal and interest payments, is determined by the characteristics of the financing track – CPI-indexed, unindexed, or foreign-currency-indexed; fixed or variable interest rate; and the mortgage term. The monthly payment can be influenced by changes in economic parameters: the rate of interest and the rate of inflation, except in the case of an unindexed fixed-rate loan.
In the course of 2022, the Bank of Israel raised the interest rate by 2.9 percentage points, and, by July 2023, had raised it by another 1.5 percentage points. At the same time, annual inflation reached a peak of 5.4% in January 2023. These two variables have a significant influence on the payments towards principal and interest on mortgages taken out to buy a home. Nonetheless, while there is a lively discourse surrounding the increasing financial burden as a result of the Bank of Israel’s interest rate decisions, the discussion of the effects of inflation on mortgage holders and on consumers in general is much more limited. The inclusion of this issue in public discourse is important since the main purpose of raising the interest rate is to reduce inflation and return it to the target range set by the government, i.e., 1%–3%.
The study presents a framework for understanding these changes and their effect on household expenditure. “Most people only look at the increase in their mortgage payments, but an interest rate increase has another important effect, that is, to reduce inflation. The study shows significant variation across the various mortgage tracks. It is important to understand that these differences are amplified during periods of interest rate increases and high inflation,” says Dr. Labib Shami. He adds, “The study is also an important tool in financial literacy since it enables an individual who is not familiar with the issue to understand the influence of changes in the interest rate and in inflation on mortgage payments according to the various tracks.”
How was the research conducted?
The researchers differentiated between the various mortgage tracks and examined their sensitivity to a change in the Bank of Israel interest rate on the one hand and inflation on the other. Ori Oberman: “In order to illustrate this sensitivity, we looked at two hypothetical scenarios and analyzed the effect of each of them on monthly mortgage payments, based on data for October 2022. In the first, the Bank of Israel does not raise the interest rate and inflation stays high (at an annual rate of 5.3%), and in the other, it raises the interest rate by 1 percentage point, and as a result, inflation drops to an annual rate of 2.9% (according to the forecasts at that time).”
The two scenarios are assessed by means of a “representative” mortgage of NIS 1 million financed according to 60% of the home value, and with a monthly payment that amounts to about 30% of disposable income for a 25-year period.
Household saving resulting from a reduction in inflation is greater than the increase in the monthly mortgage payment resulting from the interest rate increase
According to the first scenario (no interest rate increase and inflation remains high), the addition to monthly payments for all mortgage holders totals about NIS 54 million. In the second scenario (a 1 percentage point interest rate rise and a drop in inflation to 2.9%), the total increase in monthly payments is about NIS 141 million (which affects only mortgages whose interest rate is updated in that month). At face value, it appears that a rise in the interest rate harms mortgage holders by NIS 87 million.
However, if the overall effect of inflation on households (apart from the effect on mortgages) is taken into account, a different picture emerges. The average consumption expenditure for close to 3 million households in Israel is NIS 16,000 per month. According to the research estimates, a decrease of 1% in the CPI reduces the cost of consumption (in nominal terms) by 0.5%. Therefore, a reduction in inflation from 5.3% to 2.9% will lead to a decline in average monthly expenditure of NIS 192 per month and an aggregate saving of NIS 518 million per month for all households. For mortgage holders, which constitute 40% of Israeli households, this represents a saving of about NIS 208 million in contrast to the financial loss of NIS 87 million resulting from the rise in the interest rate.
“The results of the research show that in the short term the losses due to inflation are much larger than those due to the increase in the interest rate. Over time, once the Bank of Israel’s interest policy has succeeded in returning inflation to the target range, it will also be able to lower the interest rate. In such a situation, everyone will benefit – households that do not have a mortgage as well as those that do,” according to Prof. Benjamin Bental.