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 consumer prices and an erosion of real wages, is increasing the economic burden on households and is raising the cost of living.
Taub Center researchers Dr. Labib Shami, Ori Oberman, and Prof. Benjamin Bental have conducted a study that combines a look at alternatives of heavier mortgage payments due to interest rate increases and that resulting from inflation in the absence of Bank of Israel measures.
Israel housing loan tracks
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 duration. 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.
Over 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%.
For the purposes of the study, the researchers differentiated between the various mortgage tracks and their sensitivity to changes in the Bank of Israel interest rates on the one hand, and inflation, on the other. In order to show the sensitivities, they proposed two hypothetical scenarios and analyzed the influence of each one on the monthly mortgage payments based on data for October 2022. In one scenario the Bank of Israel did not raise interest rates and inflation remained high (at an annual rate of 5.3%); in the second scenario, the Bank of Israel raised the interest rate by 1 percentage point, and as a result, the inflation rate declined to an annual rate of 2.9% (according to forecasts at that time).
The analysis shows the following:
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.
In conclusion, the presentation in this study shows that the damage of inflation is far greater than that caused by raising the interest rate. Over time, it is expected that the Bank of Israel policy on interest rates will succeed in returning inflation to within the target limits, and when this happens, the Bank can lower interest rates as well.