The effect of mortgage interest deduction and mortgage characteristics on house prices

In many countries, house prices are overvalued according to price-to-income ratios. We propose that the borrower’s ability to pay (ATP) through a mortgage is a long-run house price fundamental and find convincing evidence by means of cointegration tests, granger causality, and an elasticity of house prices with respect to ATP close to one. ATP incorporates the effect of a decreasing trend in interest rates, changes in mortgage interest deduction and mortgage characteristics. We apply the model to the United States of America, United Kingdom, Belgium, the Netherlands, Sweden, Norway, Finland and Denmark. The results provide an intuitive alternative to standard house price models.