Increase In Interest Rates example essay topic

Firstly, I will deal with the factors which can affect the demand for houses in an economy. In many people's opinion, the single most important factor which affects demand for housing is interest rates. This belief is held because for most people, the cost of purchasing a house is so great that the only way they can afford to do so is to take out a mortgage from a bank or building society. One of the main conditions that banks and building societies apply to mortgages is that during the course of the mortgage, interest will be paid on the loan.

Although it is possible to have a fixed rate mortgage - where the rate of interest which will be paid is fixed at a constant level throughout the mortgage- most mortgages are variable rate mortgages, where the amount of interest which will be paid varies throughout the mortgage [1]. By increasing interest rates, the government can control how much money people have in their pockets. The variance of interest rate can be used to control much of the economy, including inflation. This is known as monetary fiscal policy.

Interest rates have such a large affect on the economy because such a large percentage of the population has a mortgage and so is vulnerable to interest rate rises. An increase in interest rates can greatly increase the amount of money that a household has to pay each month. If people without a mortgage who are considering taking one out to cover the cost of a very expensive purchase see that interest rates are high then they are likely to be wary of taking out a mortgage, as they know that they will have to pay a greater amount of extra money each month. Because people may be put off taking out mortgages, they will be unable to purchase a house, so this will cause demand for houses to fall. This is known as a slump in the housing market. Conversely, if people see that interest rates are low and they are considering the possibility of purchasing a house, they may decide to go ahead with their purchase due to the fact that it will be more affordable- at least in the short run- due to the lower interest rates.

Variable rates will also make mortgagors vulnerable to fluctuations in interest rates as even small changes in the interest rate can have a big effect on the outgoings of those with large mortgages. When rates rise steeply, one likely result is an increase in the number of mortgagors who cannot afford to make their monthly payments under the mortgage agreement and who fall into arrears. If this happens, in time, unless the agreement is renegotiated, the mortgagee may choose to exercise its right to take possession of the property (repossession), with a view to selling it and recovering all monies outstanding under the mortgage agreement; any amount the sale raises above that which is owed to the mortgagee belongs to the mortgagor. However, a high number of repossession actions is one factor that contributes to a slump in the property market, which may mean that sale price will not even cover the outstanding amount. Another factor which can affect the demand for housing is unemployment. High unemployment tends to lead to a decrease in demand for houses for several reasons.

The main reason for this is that because in a period of increasing unemployment, job security tends to be lower than at a time of decreasing unemployment [2]. This means that if people cannot be sure that they are going to have a regular monthly income for a long period of time, they are unlikely to take out a large mortgage on which there is a high probability that they will be unable to make all of the repayments. If enough people think in this way then this will lead to a noticeable slump in the demand for housing. Another reason why high unemployment can cause a decrease in the demand for houses is that due to low job security workers are unlikely to ask for high wages or wage increases. This means that in general, people are likely to be less well off. Because people are poorer, the likelihood that they would be considering taking out a mortgage is decreased.

This in turn leads to a decrease in demand for houses. However, in a period of low unemployment where job security is high, demand for houses may increase due to the fact that people feel that they are more able to afford the cost of a mortgage. If they believe that they will be employed for a long period of time, or they feel that they are able to demand high wages, they will be more likely to take out a mortgage as there is a greater probability that they will be able to repay the loan. A third factor that could influence the demand for houses is the amount of tax that people are paying; and in particular the amount of income tax. If income tax rates increase, people will become less able to afford a mortgage, so the possibility of their home being repossessed increases. If a large number of homes are being repossessed, people will be put-off purchasing a house.

Also, people who are considering taking out a mortgage will be less likely to do so because they will be less able to afford it due to the fact that they are paying more tax. Both of these effects are likely to cause a slump in the housing market. Conversely, if tax rates are low the state of the housing market will improve due to the fact that people will feel that they are more able to afford the added cost of a mortgage. However, if they take out a mortgage at a time when tax rates are low, there is always the possibility that tax rates will increase at a later date.

[1] The interest rate is set by the lender, but it is usually in line with the rate set by the Bank Of England, which is turn is likely to respond to changes in the interest rates of the main world banks, most of which are in America. [2] This is because there is a large labour pool from which to draw replacement workers. However, there are exceptions to this rule, for example people in the professions like doctors and lawyers tend to have a high degree of job security at all times.