How interest rate cuts could hurt consumer spending

Amid economic stimulus to encourage spending, Chinese Mainland households choose to pay off their mortgages early, a new study finds

Featured faculty: Jiang Wenxi and Gao Zhenyu
Written by Putro Harnowo

During an economic downturn, central banks normally launch a stimulus package to boost economic activity by lowering interest rates. Commercial banks as lenders adjust their interest rates based on the benchmark set by the central bank. Reducing interest rates eventually translates into smaller monthly mortgage payments, allowing households to spend more and boost consumption.

When the US central bank cut its interest rate in September 2024 for the first time since 2020, consumer sentiment soared as they found relief from high loan payments. The same measures were also taken in Chinese Mainland. The People’s Bank of China has adjusted its benchmark interest rate, the loan prime rate (LPR), multiple times from 4.25 per cent in September 2019 to 3.1 per cent in March 2025, to stimulate economic growth.

Oddly, lowering LPR doesn’t seem to help domestic spending much. A new study finds that an interest rate cut doesn’t directly and smoothly translate into more money at the household level. It turns out that many Chinese Mainland households responded to the reduced LPR with mortgage prepayment, or paying off their mortgage early, and cutting their consumption.

“We observe a negative correlation between interest rates and mortgage prepayments in Chinese Mainland,” says Jiang Wenxi, Professor of Finance at the Chinese University of Hong Kong (CUHK) Business School. “In cities where more households prepay their mortgages, essential and non-essential consumption declines in the following months.”

In his latest study, Mortgage prepayments in China and monetary policy transmission, Professor Jiang and his colleague from the same department, Associate Professor Gao Zhenyu, examine what motivates households to prepay their mortgages. Caixin has reported that total mortgage prepayments in 2022 reached 4.7 trillion Chinese yuan (US$700 billion), accounting for 12 per cent of all outstanding mortgage loans, and continued into the first half of 2024.

Professors Jiang and Gao’s study discovers households that prepay their mortgages on average use up more than 70 per cent of their savings and reduce their spending by 2.3 per cent. “This explains why, despite monetary easing efforts since 2019, consumption growth and economic stimulus in Chinese Mainland have been weaker than expected,” says Professor Jiang.

“Households with greater wealth, higher levels of education, and better credit scores are more responsive to the gap between their mortgage rates and LPR, making them more likely to prepay their mortgages.”

Professor Jiang Wenxi

Unique characteristics of Chinese Mainland’s mortgage market

Home loan arrangements vary across markets, but the most common types are adjustable-rate, where the mortgage interest rates fluctuate over time in line with the central bank’s benchmark interest rate, or a fixed-rate mortgage, where the mortgage interest rate stays the same since the loan was taken.

When the central bank lowers interest rates, borrowers with adjustable-rate see lower monthly mortgage payments and more money for spending, making the economic stimulus swiftly affect households. For borrowers with fixed-rate mortgages, they can opt to refinance, which involves replacing the existing mortgage with a new one with better terms.

However, refinancing is prohibited in Chinese Mainland and mortgage rates are mostly adjustable at a very slow pace. Mortgage rate is based on LPR and “local margin” set by the city, which remains fixed throughout the loan term. Local margin varies depending on local rules, but tends to follow the direction of the central bank after a while. Therefore, lower LPR only results in small changes in mortgage rates much later. Researchers called this “mortgage rate rigidity.”

Before 2019, the benchmark interest rate stayed the same for a long time, making the gap between mortgage interest rates and returns on savings relatively small. When LPR was lowered, the rigidity of mortgage rates made the gap with earnings from savings grow more significant, and borrowers started to realise that carrying a mortgage is getting more and more costly.

How interest rate cuts weaken domestic consumption

In the study, Professor Jiang and Professor Gao, as well as Wang Kemin and Ren Haohan from Fudan University, analyse extensive mortgage data obtained from a major state-owned commercial bank in Chinese Mainland. They track borrowers’ payment and consumption behaviour between October 2019 and May 2024 from a randomly selected sample of 100,000 outstanding mortgages.

The researchers find that as the LPR declined, more and more borrowers prepay their mortgages. The prepayment ratio rose to 8.1 per cent by the end of 2021, stalled in 2022 due to the pandemic, and then peaked at 11.5 per cent by early 2023, as shown below. “Borrowers often decided it was best to cut back on both spending and saving so they could pay off their mortgage faster,” says Professor Jiang.

Further analysis shows that consumption of discretionary or non-essential items is particularly affected. “Households with greater wealth, higher levels of education, and better credit scores are more responsive to the gap between their mortgage rates and LPR, making them more likely to prepay their mortgages,” Professor Jiang adds. “The larger the gap between the mortgage interest rate and the LPR, the more likely they are to prepay.”

Designing more effective policy

In August 2023, the People’s Bank of China announced housing credit policies by lowering mortgage interest rates for first-time home buyers and local margin in some cities. The policies expanded the criteria of first-time home buyers, enabling certain borrowers to reset their local margin to a lower rate.

Given the fixed-rate feature of local margin is one of the causes of mortgage rate rigidity, lowering this extra fee helped mortgage rates move closer to the LPR. Around 25 per cent of households in the sample were qualified for this adjustment.

The researchers find that these qualified households were significantly less likely to prepay their mortgage and showed increases in their household consumption. “Policies that directly address mortgage rate rigidity can help monetary policy have a stronger and quicker effect on borrowing and spending decisions, improving how well monetary policy works,” says Professor Jiang.

This finding aligns with the policy initiative introduced in September 2024  by the People’s Bank of China, which aims to further strengthen monetary policy transmission through the household channel. The policy initiative features a new mortgage rate pricing scheme, which allows local margins to adjust to market conditions and shorten the LPR adjustment period from one year to as little as one quarter.

These measures enable the mortgage interest rates to respond more quickly to changes in the benchmark interest rate, reducing rigidities in the mortgage system. “As a result, mortgage prepayment activity has slowed remarkably since September 2024,” Professor Jiang adds.