Can you explain how raising mortgage rates help the economy? Everywhere it seems prices are high now and I assume people are already stretched thin. So how does rising mortgage costs help people? And do banks keep all the extra profit from the higher mortgage payments?
Something to keep in mind is that The Economy is a big collection of interconnected topics. The Economy isn’t just how much money people are making or how affordable goods and services are. Those are parts of The Economy, but The Economy is also the stock market, loans, and the flow of trade between countries. There are a lot of pieces and, sometimes, something that helps one part of The Economy hurts another part.
I mention this because you’re right: the prices of a lot of things are high right now. Rising interest rates are making owning a home more expensive which is making it harder for people to make their mortgage payments, which reduces the amount of goods and services they can afford. This makes it harder for people, especially new property owners, to buy things and get by.
This probably makes rising mortgage rates seem like a Bad Thing because they’re making it harder for a lot of people to budget and get by. However, this Bad Thing for one part of The Economy (home owners buying things) helps in another way.
Inflation, which is a big part of what drives up prices, happens when there is too much money chasing not enough stuff. (This is an over simplification, but bear with me.) Basically if you have a bunch of people with a lot of money and not enough stuff being supplied, the cost of the limited amount of stuff goes up.
For example, if you walk into most corner stores and grocery stores there are probably thousands of chocolate bars on the shelves. The bars are cheap to make and there are tonnes of them, so they don’t cost much. You can buy one for $2 or $3. But imagine what would happen if you and your five friends walked into a store with $50 each and there was just one chocolate bar in the store. Between you and your friends you have $300 and there is one chocolate bar. The store is going to see there is a lot of money available, but very few items to buy and raise the price. With the higher price, fewer people will bother to buy chocolate.
Eventually the store will restock its supply of chocolate and the price will come down. Or people will refuse to pay super high prices for chocolate and leave the store. The lower demand will cause the price to drop.
What is happening with mortgage rates is similar. There were a lot of people trying to buy houses (and a lot of other things). People were borrowing large amounts of money at low interest rates and grabbing all the houses, cars, and other stuff they could afford. This was driving demand higher and there were more people seeking new stuff (like houses) than there were items available. Since there were lots of people with access to cheap mortgages and not enough houses and other stuff, the prices of houses and other items went up quickly.
Raising mortgage rates means buying and owning a house is more expensive. Which means fewer people want to buy right now and more people want to sell their existing houses. This lowers the demand for houses and other goods. As demand lowers, prices stop rising as quickly and everything (houses, cars, and other goods) slowly become more affordable for everyone.
Put another way, raising the cost of mortgages and therefore the cost of owning property is Bad in the short-term for people who own property or want to buy it. Their budgets are squeezed tighter. However, in the long-term, making home ownership less attractive (using higher mortgage rates) reduces the amount of money people are spending, particularly on houses. This cools the market and brings prices back down, which is Good for most people.
Basically, when inflation is happening quickly prices on everything are shooting upward. One of two things will usually slow inflation and bring prices back to a reasonable level. Either the supply of goods can be increased or the amount of available money can be reduced. Supply can be increased by building more stuff, creating more factories, and opening more supply lines. The amount of money can be reduced by raising taxes, increasing interest rates on loans, and lowering government spending. These are just a few simple options, but they are designed to cool inflation and stabilise The Economy.
As for whether banks keep the extra money from increased mortgage rates, the short answer is: no. Banks typically borrow money at a base interest rate and then loan it out to other people at that interest rate, plus a few percent.
In other words, if the bank is borrowing money at a base interest rate of 1%, it might be loaning it out for mortgages at 2%. If the base interest rate rises to 3% then the bank will loan it out at 4%. The amount the bank is making off the loan usually doesn’t change because the difference between the two rates stays close to the same.
This is another case of something being Bad for one part of The Economy and Good for another part. People hit with higher mortgage rates right now are feeling the Bad effect of higher monthly payments. However, people who have savings accounts and GICs are benefiting from receiving higher interest payments on their savings. They’re receiving a Good thing (higher interest payments) while people with loans are experiencing the Bad effect of higher costs.
For most of the time between the years 2010 and 2021 the situation was reversed. People with loans and mortgages were paying virtually no interest (which was Good for them). Meanwhile people who had savings in their bank accounts were making almost no interest off the money (which was Bad for them). Whether the components of The Economy are moving in a Good or Bad direction is often a matter of perspective – whether you are buying or selling, saving or borrowing, investing or trying to cash out.
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