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May 1984, 
Vol. 66, No. 5
Posted 1984-05-01

Has the Deregulation of Deposit Interest Rates Raised Mortgage Rates?

by R. Alton Gilbert and A. Steven Holland

R. Alton Gilbert and A. Steven Holland assess the effects of the removal of deposit rate (Regulation Q) ceilings on the interest rates charged on mortgage loans. It is widely believed that the phase-out of interest rate ceilings on deposits at banks and thrift institutions has contributed to the rise in U.S. interest rates and, in particular, U.S. mortgage rates, over the last few years. In contrast to this popular opinion, Gilbert and Holland explain that economic theory suggests that deregulation, other things the same, should result in lower rates than would otherwise be observed. Critics of this theoretical analysis of deregulation have noted that the average interest rate on mortgage loans, the average cost of funds for savings and loan associations, and market interest rates in general have risen substantially since the introduction of new types of deposits with flexible interest ceilings (or no ceilings at all). More importantly, mortgage rates have moved higher relative to government bond rates of similar duration since deregulation began. However, Gilbert and Holland show that this increase in interest rate spreads is not related to deregulation at all; instead it is due to some crucial differences between conventional residential mortgages and government bonds as debt instruments. In particular, the relative rise in mortgage rates has resulted from more variable interest rates (which produced a higher premium on mortgages for the option of prepaying a mortgage loan) and the recession in the early 1980s (which raised the premium on mortgage loans to cover the higher risk of default on mortgages).