Interest Rate Cuts and You

This morning we learned of another interest rate cut, the second in the past month. The Bank of Israel lowered the interest rate by 0.25%, following a similar cut about two weeks ago.

Reducing the Bank of Israel's interest rate, by which the prime interest rate is calculated, has a significant impact on mortgages and the economy as a whole.

In this article, I will attempt to examine the reasons that led to the interest rate reduction, as well as the impact of this step on mortgage holders on the one hand, and future mortgage holders, those planning to purchase an apartment, on the other.

First, the effect of the Bank of Israel's interest rate on the prime component of existing or new (planned) loans:

The prime component of the mortgage is recalculated every month. The term “prime” refers to the Bank of Israel interest rate plus 1.5%. Therefore, if a person has a prime loan with an interest rate of prime minus 0.9%, then the interest actually paid is the Bank of Israel interest rate plus 1.5% minus 0.9%. As mentioned, this interest rate is recalculated every month and therefore automatically decreases (or increases) with changes in the Bank of Israel’s interest rate.

I have existing mortgages with fixed-rate, non-indexed interest options.

The change will not affect a fixed, unlinked mortgage at all. In the longer term, you should examine whether the interest rate environment has become lower than it was when you took out your mortgage. If the answer is yes, you can save a lot of money by refinancing your mortgage.

Mortgages indexed to the consumer price index with variable or fixed interest rates

In the immediate term, the change will not affect your loan repayments. One of the goals of reducing interest rates, as will be explained later, is to increase inflation. Increasing inflation will increase your debt to the bank (the debt is linked to the index in these tracks) and your monthly repayments. Holders of variable-rate loans may benefit if their interest rate change date falls within this period.

Individuals planning to purchase an apartment in the future but who have not yet signed a purchase agreement for a specific apartment:

When interest rates are low, people feel they can afford to buy an apartment at a higher price. For example: With a monthly payment of 5,000 NIS, you can borrow approximately 930,000 NIS at a prime rate of 5.1% and 1.2 million NIS at a prime rate of 2.51% (for 30 years). In other words, for the same monthly payment, the mortgage amount could be approximately 300,000 NIS higher. When people have greater ability to pay for an apartment, they are willing to pay a higher price, which is effectively what has driven the steep rise in prices in recent years. People who want to buy an apartment do suffer from the high prices, but they benefit from a cheaper mortgage. Interest rates today are about one-third of what they were a decade ago. The risk in this situation is taking out loans that are too large relative to the family’s repayment capacity should interest rates return to normal from the current extreme low levels. Another reason for the rise in prices is real estate investors, who, on the one hand, receive very low interest on their money at the bank and, on the other hand, can obtain cheap credit; thus, many of them choose to save by purchasing an apartment rather than through a bank savings plan, for example.

Housing prices are one of the main factors making it difficult for young families to manage their financial lives. On one hand, high purchase prices make acquiring a home difficult and even economically unfeasible. On the other hand, instability in rent payments pushes families to buy an apartment despite current peak prices.

High housing prices were among the main causes of the 2011 summer protests. Why then is the Bank of Israel lowering interest rates, a move which, as mentioned, could cause a further jump in housing prices?

The Bank of Israel provides several justifications for its decision:

• ·         Consumer Price Index It has risen by only 0.81% over the past 12 months. This rate of price increase is below the government’s lower target and indicates the onset of a recession. Lowering interest rates causes people to save less (saving is not worthwhile if no interest is earned on it) and to purchase more goods. This increases demand for goods and services, thereby stimulating the economy. Cheap credit for businesses and rising demand for products allow businesses to increase production and reduce unemployment.
• ·         Forex market There is a strengthening of the shekel against the dollar. This means fewer shekels are needed to buy a dollar. This trend intensifies when interest rates in other countries are lower than in Israel. The strengthening of the shekel against other currencies poses difficulties for exporters and eases things for importers (at the expense of local manufacturers). Both these trends are negative, and to mitigate them, interest rates should be aligned with those prevailing in other countries.