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#### Essay > Words: 4460 > Rating: Excellent > Buy full access at $1

# CHAPTER TWO

# 2.0 LITERATURE REVIEW

Over recent years the Central bank of Kenya has carried out annual survey on the issues related to growth of resident mortgage. The findings have shown that mortgage rates are the main impediment to growth of this sector. Indeed the recent annual survey (Central Bank 2013) identified mortgage rates as the main factor holding up uptake of mortgage in Kenya. This section will review the factors identified by different scholars as the determinants of mortgage rates. The subsequent section is the empirical analysis of studies done in different regions. The last section is the overview of literature review.

# 2:1 THEORETICAL LITERATURE REVIEW

According to Mandura (2009 pp 228) mortgage can be defined as a type of a debt fashioned to back investment in real estate. Such debt is protected by property; therefore, if the borrower fails to pay the property can be seized. Jacobus (2009 pp101) argues, that mortgage is an instrument that makes property security for repayment of a debt. A mortgage therefore, is not conveyance of the property since it does not operate to transfer title from the borrower to the lender. It only pledges the property as security for the due payment of the debt, thus creating an encumbrance on the property.

**2.1.1 COMMON TYPES OF MORTGAGE INTEREST RATES**

There are two main types of mortgage rates: Adjustable Mortgage Rates (AMR) and Fixed-Rate Mortgage.

**2.1.1.1 Adjustable Rate mortgage**

Following Jacobus (2009 pp 277) Adjustable rate mortgage can be defined as a mortgage which interest rates rise and fall with changes in prevailing interest rates. It can also be said to be type of mortgage where interest rate rises and fall with changes in market conditions. (Mandura 2009 pp 228).When the level of interest rates in open market rises and falls, the interest rates the mortgagor is entitled to receive rises and falls. Therefore, it is possible to reflect as closely as possible what saving institution receives from borrowers and what must be paid to attract funds. ARMs therefore, transfer part of the interest rate risk from the lender to the borrower, and thus are widely used where fixed rate funding is difficult to obtain or prohibitively expensive. The initial interests rates under the ARM are lower the fixed-rate mortgage of equal maturity. Therefore the ARM may be preferable to some buyers since it may make the difference on whether they qualify for a desired home loan or not. On the contrary, ARM may be disadvantageous to the borrower because when the interest rates rises the borrower will pay more.

** **

** 2.1.1.2 FIXED-RATE MORTGAGE (FRM)**

Fixed-rate mortgage (FRM) is a mortgage in which the interest rate is constant and does not change during the term of the mortgage. The interest rate is fixed at the time of origination. It requires regular payments during the life of the loan, of sufficient size and number to pay all interest due on the loan, and reduce the amount owed zero by the end of the loan’s maturity date (Jacobus 2006 pp187).

Lenders of fixed interest loans are exposed to interest rate risk. This is because these mortgages are financed from short term deposits. This is because they generally rely on short term deposits to avail long term mortgages loans. Incase interest rates increase overtime, the financial institutions will incur an increased cost of obtaining funds, consequently, reducing their profits margin. On the other hand, borrowers will not benefit from reducing interest rates; however, they will not be affected by increasing rates.

**2.1.1.3 Capped Rate Mortgages**

The borrowers may protect themselves from interest rates increases by taking a capped rate mortgage. This type of mortgage rates fixes the upper limit of the rates while allowing the rates to move downwards (Redhead, 2008 pp 104). The loan provider buys an interest option from a dealer who undertakes to compensate if the interest rates increases. The payments for the option to the dealer reflect the risk which is passed to the borrower.

** ****2.1.2 Determinants of Mortgage Interest Rates **

**2.1.2.1 Mortgage Rates and inflation-The Fisher Hypothesis**

This theory asserts that there is one-for-one relationship between inflation and interest rates (Thomas 2005, pp 105).According to Domar (2012 pp. 516). Actual interest rate changes as inflation changes. This can be explained by the fact that lenders being rational agents will require compensation to their purchasing power occasioned by general increase in prices.

(1)

Where the nominal interest rate, r is is the real interest rate and β is the extent to which nominal interest rate change as expected inflation change. In case the real interest rates are constant over time, β=1. Real interest rate is the disparity between the nominal interest rate and expected inflation (Domar, 2012 pp.516).

(2)

Pozdena (1988 pp27), observes that when lenders advance a loan they form some expectations about the probable rate of inflation. If they expect an inflation rate of 8 per cent per annum, they will incorporate 8 percent to the annual interest rates. Therefore, an increase in inflation expectation will cause long term interest rates including mortgage rates to increase.

**2.1.2.2** **Central Bank Rate** ** **

** **It is the role of the central bank to control inflation. One of the instruments it uses to achieve this is the bank rate. Taylor (2006, pp.640) argues that when the inflation rises the central bank response by raising the nominal rate and as a consequence the real interest rates rises. Consequently, exports, consumption and investment reduce. The converse is true. Asso, et.al (2010) observes that the Taylor rule can be used to set the Central bank rate subject to some conditions and can be explained by the following equation:

(1)

Where,

y= deviation of GDP from the trend

p= inflation over previous four quarters with a target of 2%

The GDP is growing on its trend at about 2% per annum so that y=0

The ax post interest rate will also equal 2

Foote, Murphy and Sentowski (2008) points out that although the Federal Reserve does not set long term interest rates such as the mortgage rates, they influence inflation through short term interest rates. The long term interest rates for instance mortgage rates incorporate the future inflation expectations. Therefore, there is a relationship between the short term interest rates set by Federal Reserve and long term inflation expectation. In 2011 the interest rates including mortgage rates were declining in the United States. Lieberman and Hall (2013 pp 111) notes that although there was no consensus on the reason behind the decline, the Federal Reserve rate played a key part. According to IMF (2005 pp1993) the South African interest rates were linked to short term rates and they fluctuated between 13 to 24 per cent which impeded growth in housing sector. However after the introduction of an inflation targeting regime, interest rates have reduced substantially lowered leading to a vibrant property market.

** **

**2.1.2.3 Bond Prices and Mortgage interest Rate**

Killin and Derespins (2012 pp 42) observes that there is an inverse relationship between mortgage rates and bond prices; that is, when the prices of the bond increases, the mortgage rates decreases. The converse is true. This may be explained by the fact that the bond prices are fixed at maturity. If we assume that the price of the bond at maturity is sh.1, 000 and the current price of the bond is sh. 900 and there are 5 years left, if the interest rates are increasing the prices of the bond will move downwards.

**2.1.2.4 Demand and Supply for Loans.**

The changes in the interest rate can be explained by the demand and supply concept (Rockwell 2006 pp 260). In case there is high demand for mortgage loans the interest rate will increase. On the other hand, a low demand for mortgage rates is followed by low interest rates. Killin and Derespins (2012 pp 41) observes that while mortgage rates move with other interest rates, the actual rates depends with the supply and demand for mortgage loans. The supply of mortgage is determined by the willingness of the financial institutions to invest in the real estate. Furthermore, financial institutions depend on supply of money which is determined by factors such as the amount of customer deposit and the central bank lending rate. The demand side depends on the income levels and the general economic conditions.

**2.1.3.1 Interest Rates Theories**

**2.1.3.2 Loanable Funds theory**

Mandura (2006 pp 213) argues that the loanable funds theory can be used to explain the movements in the general level of interest rates in a country. According to this theory, the market interest rates depends on the factors that influence the supply and demand for loanable funds. The demand schedule is basically dependent on business needs for investment and cash balances for day-day transactions, while, the supply side depends on the additions to monetary supply as well as existing savings (Mukherjee 2005). The monetary supply is dependent on money creation by non financial and financial institutions and commercial banks. Interest rates are determined by the interaction of these demand and supply schedules. Events that affect income will cause a shift in the demand curve for loanable funds. If borrowers expect a decrease in future tax rates, they will increase their demand for loable funds, thus, the demand curve will shift outwards. Ceteris Peribus, suppliers of loanable funds are willing to supply more funds if the interest rates are high. At equilibrium the demand and supply of loanble funds must be equal. If the demand increases without the corresponding increase in supply, there will be a shortage of funds, consequently, the interest rates will increase. The converse is true.

**2.1.3.3 Liquidity preference theory (Term Premium Hypothesis)**

Following Keynes, Mankiw(2007 pp 749) argues that interest rates adjust to balance demand and supply for money. Liquidity preference is the preference to hold money in cash, rather than claims against others. However, one would part with liquidity only if rewarded for it. The consideration for parting with the liquidity is the interest. According to this theory interest is regarded as the price of services of money and is determined by demand and supply of money. Money supply is a function of the Central Bank. Liquid money is preferable as opposed to other assets with higher rate of return because it can used to transact. Reilly and Brown (2011, p.652) Postulates that investors add increasing liquidity premiums to existing rates to arrive at the actual rates. At equilibrium interest rate, the quantity of money demanded balances the quantity supplied. When there are deviations from the equilibrium, there are adjustments of portfolios and assets such that interest rates tend towards the equilibrium.

** **

**2:2 EMPIRICAL LITERATURE REVIEW**

Page (1964) examined the relationship between mortgage interest rates and issues lenders relate with the threat of failure to pay. Specifically, he investigated the suggestion that mortgage rates differ with property value, lender assets, loan-to-assets ratio and risk of default. Total logarithmic regressions based on the theory of goodness of fit were used to measure the relationship between mortgage rates and the independent variables. Data was derived from monthly survey mortgage rates in Chicago conducted by Federal Reserve Bank. The survey respondents included thirty five saving and loans associations, twenty one banks and five mortgage and insurance companies and covered the period between 1958 and 1963.It was found that there negative relationship between mortgage rates and lender assets but there was considerable positive relationship with loan-to-assets ratio. However, the positive relationship disappeared in cases where the loan was insured by federal agency.

Toolesman, Jan and Jacobs (2007) studied the proposition that prices are rigid downwards application to mortgage rates. In particular, the suggestion that mortgage rate follow an increase in capital market rate rather than a decrease. A 10-year capital market rate running between 1978 and 2000 for Netherlands was used. It was found that during the period of downward movement in interest rates, the gap between the mortgage and the capital market rate was widening.

They concluded that switching costs and tacit price coordination are the likely causes of mortgage rate asymmetric response to capital market rate. The study were consistent were consistent with the similar the one carried out by Sirmans and Smith (2012). They found that there was a strong relationship between mortgage rate and capital market rate and especially the 10-year treasury rate. The method of examination was regression and the 30-year mortgage rate and 10-year treasury rate data was obtained from the Federal Reserve. When 30-year mortgage rate was regressed against 10-year treasury rate, there was an r- squared of 0.969. A 30-year mortgage rate was also regressed against Swap rate and corporate bond rate. Notably, the Swap rate was found to have a strong relationship (r-squared of 0.985) and with 30-year mortgage rate than 10-year treasury rate because there is a default risk premium not explained by treasury rate.

Similar studies by Eichegreen (1984) were carried to investigate the causes of mortgage rates regional differentials between Eastern states of USA and other regions. He observed that mortgage interest rates tended to be higher on average in Western regions than Eastern States. He postulated that interregional interest rate differential could be explained by risk premium charged by fin.............

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