Imagine a world where the bank pays you to take out a loan. This is what’s known as a negative interest rate, and while it may seem counterintuitive at first, it can have economic benefits in a struggling economy. So, how do negative interest rates work?
During an economic downturn, banks may turn to negative interest rates as a way to encourage borrowers to keep spending. Even though these interest rates are below zero for the Federal Reserve, it may not mean the same for individual borrowers. This blip in the system could benefit your finances, but it could hurt them as well — here’s how.
What Are Negative Interest Rates?
Negative interest rates earn you interest payments on your loans and charge you interest on money saved. Interest rates were created to earn you money on your savings and charge you for money borrowed. With negative interest rates, the rules are reversed.
Even though negative interest rates haven’t occurred in the U.S., they have in other countries during a dip in the economy, including in Denmark and Sweden. Negative interest rates encourage more spending to help boost the economy.
Interest rates are, in a regular economy, a percentage you pay to borrow money or earn on savings stored at a bank. When these interest rates go from positive to negative, the lender pays you for your loan and charges you for your savings stored in their accounts. This may cause you to take out a loan or store savings anywhere but a bank.
How Do Negative Interest Rates Work?
First, it’s important to understand what would cause interest rates to fluctuate. Inflation happens when spending increases and deflation happens when spending decreases. Deflation can be caused by various influences, like households restricting money during the COVID-19 pandemic. Many people began spending less due to the scarcity of resources or losing their job.
When less money is spent in an economy, the Federal Reserve decreases their interest rates. When interest rates go from positive to negative to encourage people to take out loans and banks to distribute their cash. This is a desperate measure for banks to help stimulate an economy that’s restricting money.
What Does This Mean for Your Wallet?
When interest rates are negative, that doesn’t mean necessarily you’ll earn money on loans or pay for your savings. These interest rates may be negative for banks borrowing from the government, but not always for individuals borrowing from the bank.
In some circumstances, negative interest rates are negative at the government level, but not at commercial banks. Banks still have to make money off you — so they upcharge loans just like merchants upcharge merchandise. Generally, the bank’s upcharge in interest rates will still be at a low rate, around 1 to 2 percent.
It May Be Cheaper to Borrow Than Normal
When interest rates plummet, you may have the opportunity to get loans at lower rates. For instance, if you have a student loan that has an annual percentage yield (APY) of 5 percent, you may consider refinancing it at a negative 1 percent APY. This could save you money on your monthly payments by hundreds, if not thousands, a year.
During a period with negative rates, houses may be cheaper and loans may be easier to get. If you’ve been thinking about buying a home, you could score big during an economic downturn. Before making any rash decisions, be sure to check in on your finances to ensure this is a good decision in the long-term.
Your Investments May Suffer the Consequences
For the investments you already have, there may be some negative consequences. If interests decrease, so could your savings APY. Instead of earning 5 percent APY on your savings, you may not earn anything, or even worse, pay fees for it.
In an ideal world, your savings contributions would earn you interest over time, not charge you. While the U.S. has never had negative interest rates, it’s worth knowing what these rates could do to your finances. If the economy were to take a turn for the worse, you may want to consider different savings options to avoid these fees.
Risks vs. Rewards
The real question is, could negative interest rates benefit or hurt you? Simply stated, we don’t know. Since the U.S.’s interest rates haven’t ever gone into the red, there isn’t enough information out there. But, here are some pros and cons of how these rates may affect your wealth.
- Pro: More affordable to borrow. Lower interest rates encourage spending. You may be able to take out a loan for a house or car at lower rates than normal. At a locked-in interest rate, you could save more than usual on your monthly interest payments.
- Con: Current investments could suffer. Your investments could cost you instead of making you money. For instance, your savings stored at a bank may charge interest fees, and your assets, like your house, could decrease in value.
- Negative interest rates could earn you money on loans taken out while charging interest on money saved.
- When interest rates are negative, they may not be negative for you. Loans you take out may benefit from low interest rates, but not as low as the government interest rates.
- When interest rates decrease, you may have a better chance of locking in a loan at a cheaper rate.
- The U.S. has yet to hit negative interest rates, but it’s always great to learn about the unexpected!
While you may be able to buy a house at a lower interest rate, it’s important to take this time seriously. Always be aware of your budget before making financial decisions. Avoid spending outside of your means and see how much a given investment may cost you in the long run. If you see more positives than negatives on an investment opportunity, go for it!
Sources: Federal Register