Six years after the financial crisis, the Federal Reserve and other central banks are still looking for answers to whether the unconventional monetary policies adopted following the crisis — including lowered interest rates — have been effective in helping American households and the larger economy. The persistence of so many debt-burdened households, widespread unemployment, and relatively low economic growth has only increased the debate among economists and policymakers.
Many experts believe a decline in interest rates has a large effect on households’ consumption by providing extra spending cash through either a decrease in household borrowing costs — lower interest rates make consumers more likely to refinance existing loans — or an increase in wealth, by lowering their already existing monthly debt payments. However, others are skeptical, noting that difficulty in obtaining credit and already high debt levels might limit the ability of consumers to take advantage of low interest rates. “The idea is that two things will happen with low interest rates: banks will start lending again so people can borrow to buy houses; and homeowners can refinance their mortgages, giving them more disposable income, which boosts the economy,” says Professor Marco Di Maggio. “Unfortunately, these are all just theories. Up to this point, there was no evidence that low interest rates really have these effects.”
To determine whether households did actually benefit from the current period of prolonged low interest rates, Di Maggio worked with Amir Kermani of the University of California, Berkeley and Rodney Ramcharan of the Federal Reserve Board. The researchers investigated the role of monetary policy in shaping households’ purchasing and saving decisions using a variety of data, including consumer credit reports, mortgage information, and homeowner credit files — which track debt types and delinquencies — from the Federal Reserve Bank of New York. Within these data sets, they focused particularly on households who borrowed and purchased homes with adjustable rate mortgages (ARMs) between 2005 and 2007 with an automatic reset of the interest rate after five years.
The households with ARMs that originated in 2005 benefitted from an average interest rate reduction of 3.3 percentage points when they were automatically adjusted in 2010. Overall, all households with ARMs originating between 2005 and 2007 saw an average of a $900 drop (equivalent to a 52 percent reduction) in monthly mortgage payments, giving borrowers an increased income totaling tens of thousands of dollars over the remaining life of the mortgage. “All of a sudden, you have an extra $900 in your pocket each month,” Di Maggio says. “It was a huge income influx for these households since the median income for these households is $55,000 a year.”
But what did consumers do with the money? Many put their newfound cash in drive: among these households, the probability of purchasing a car increased by at least 45 percent after the interest rate reset. On average, 40 percent of a household’s income increase went toward purchasing both durable and nondurable goods, increasing aggregate demand and benefitting the larger economy; low-income households and borrowers with underwater mortgages spent an even higher percentage of their income increase. However, another 15 percent was typically used for repaying the homeowners’ mortgage or other debt faster.
“This is something that people didn’t think about before lowering interest rates,” Di Maggio says. “If you give more money to a highly leveraged household, one possibility is that it’s not going to consume all of it. Instead, borrowers will also start repaying debts, building equity in their homes, or paying off credit cards.”
While decreasing household debt helps individual consumers’ financial pictures, it’s not so great for the economy, which depends on discretionary spending — mixed findings that policymakers can use to weigh the pros and cons when making future decisions to change the interest rate. “In the end, the economy was helped by lower interest rates,” Di Maggio says. “But at the same time, that effect was dampened by the precautionary savings incentives for these households, and more importantly by debt rigidities, as households with fixed-rate mortgages were less likely to take advantage of the lower interest rates.”
Marco Di Maggio is an assistant professor of finance and economics at Columbia Business School.