Systematic differences in interest rates for conventional fixed-rate residential mortgage loans across select U.S. cities, 1980 through 1983

Abstract

Since the 1890 Census, systematic differences in interest rates have been a recorded fact. Without further inquiry, the presence of systematic differences in interest rates would appear to violate the efficient markets hypothesis of modern financial theory. This study identified geographic locations with differing effective interest rates, contract interest rates and fees and charges from a sample of thirty-two cities for the 1980 through 1983 time period. When compared to previous research, this study took place in a period with significantly altered institutional framework. First, the Federal override of state usury laws in 1980 allowed interstate comparison of interest rates within an environment which interest rates could rise to market clearing levels. Second, due to private mortgage insurance, lenders were theoretically immunized from default risk. A number of probable causes of interest rate divergences were examined. These included default risk, loan characteristics, secondary market activity and savings and loan association performance. Significant differences in effective interest rates, contract interest rates and fees and charges were identified. Geographic locations of higher and lower rates and costs did not, however, correspond to previous empirical studies. It was hypothesized that lenders perceived all properly insured conventional mortgage loans as being equal in default risk. This hypothesis was supported by the failure to detect any association between mortgage foreclosures and effective interest rates. The institutional framework within each state failed to account for all variability of effective interest rates. This would indicate that at least one additional factor contributed to the systematic differences in interest rates and loan charges. Savings and loan associations used the secondary markets not only for liquidity, but also geographic diversification. Secondary market activity was found to be independent of rates of return to lenders. It was concluded that geographic differences arose due to inefficiencies in the goods and services markets. Residential mortgage loan financial markets were found to be efficient.