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Money, Banking and Households: Question 10

Syllabus 3.2

Multiple choice 1 mark

Chidi and his partner have been planning to buy their first home. For the past year, banks in their country have been charging a high rate of interest on mortgage loans, so the couple have kept renting and continued to save toward a larger deposit instead. This month, the central bank sharply cuts the official rate of interest, and mortgage rates fall along with it. Household income, house prices and consumer confidence have not changed.

Based only on this fall in the rate of interest, what is Chidi and his partner most likely to do?

Choose an answer to check it, then compare with the worked solution below.
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Worked solution

Step 1: Identify what the rate of interest change actually does

A mortgage is a loan, and the rate of interest is the cost of borrowing that loan. When the central bank cuts the official rate of interest and mortgage rates fall along with it, the monthly repayments on a mortgage of any given size become smaller, making it cheaper for Chidi and his partner to borrow than it was before.

Step 2: Work out the effect on the couple’s decision

Since the couple had specifically been waiting because mortgage rates were high, a fall in the rate of interest removes the main reason they were holding off. With borrowing now cheaper, and income, house prices and confidence all unchanged, the couple are most likely to take out the mortgage loan now rather than continue waiting and saving.

Step 3: Rule out the other options

  • Option A (keep renting and saving) describes the response to a rise in the rate of interest, not the fall described here. A lower rate makes borrowing more attractive, not less.
  • Option C correctly predicts that the couple will borrow, but for the wrong reason: a lower rate of interest makes saving less rewarding, not more, so this cannot be why they would choose to borrow.
  • Option D also reverses the effect on saving, and in any case predicts the wrong action. A lower rate of interest does not increase the reward for saving.

Final answer

A fall in the rate of interest makes mortgage borrowing cheaper, removing the reason the couple had been waiting, so they are most likely to take out a mortgage loan now, option B.