European Central Bank working paper finds rate rises drive non-linear default risk for ultra-low-rate variable mortgages

The European Central Bank published a working paper examining how interest rate changes affect defaults on variable rate mortgages in the euro area, finding a highly non-linear and asymmetric relationship. The analysis indicates that default risk rises sharply when rates increase, with vulnerabilities concentrated among borrowers who originated loans at ultra-low interest rates. The paper is published as research and does not represent the ECB’s views. Using European DataWarehouse loan-level data on securitised variable rate mortgages in Spain, Ireland, Italy and Portugal, the authors analyse more than 9 million quarterly observations and defaults over 2014–2019 (average default rate 0.9%). When contemporaneous rates are high, borrowers whose mortgages were originated at ultra-low rates show a markedly higher predicted default probability, reported as 2.6 times the sample average. Rate cuts have comparatively small effects, while rate increases materially raise default probabilities, including a finding that for ultra-low-rate originations, increases above 70 basis points are associated with a default probability nine times higher than similar loans with no rate change. The impact of increases also depends on rate history, with a consecutive rate increase having a three times stronger effect on default probability than an increase following a prior decrease. From a financial stability and macroprudential perspective, the paper argues these results support borrower-based measures that limit debt-service-to-income ratios and the use of interest rate stress testing at origination in periods of particularly low interest rates.