Imagine a world where the bank pays you to take out a loan. This is what is known as a negative interest rate, which may not seem intuitive at first, but it can have economic advantages in difficult economic times. How do negative interest rates work?
During an economic downturn, banks could turn to negative interest rates to encourage borrowers to continue spending. While these rates are below zero for the Federal Reserve, it may not mean the same for individual borrowers. This flaw in the system could benefit your finances, but it could also harm them – that's how it works.
What are negative interest rates?
Negative interest rates earn you interest payments on your loans and charge you interest on money saved. Interest rates have been created to make you cash on your savings and to bill you for the money you borrow. With negative interest rates, the rules are reversed.
Although negative interest rates did not occur in the US, they did occur in other countries during a downturn, including Denmark and Sweden. Negative interest rates encourage more spending to stimulate the economy.
Interest rates, in a regular economy, are a percentage that you pay to borrow money or make money on savings that are stored in a bank. When these interest rates go from positive to negative, the lender pays you for your loan and calculates the savings you have saved in their accounts. This can result in you taking out a loan or just keeping savings with a bank.
How do negative interest rates work?
First of all, it is important to understand what would cause interest rate fluctuations. Inflation occurs when spending goes up and deflation occurs when spending goes down. Deflation can be caused by a variety of influences, such as households restricting money during the COVID-19 pandemic. Many people were spending less due to scarcity of resources or job loss.
When less money is spent in an economy, the Federal Reserve lowers its interest rates. When interest rates change from positive to negative, to encourage people to borrow and banks to distribute their money. This is a desperate move for banks to take to stimulate an economy that is constricting money.
What does this mean for your wallet?
If the interest rates are negative, it does not necessarily mean that you are making money on loans or paying for your savings. These interest rates can be negative for banks that borrow from the government, but not always for those who borrow from the bank.
Negative interest rates are negative at government level in certain circumstances, but not at commercial banks. Banks still have to make money off of you – so they top up credit just like merchants top up goods. In general, the bank's interest rate premium will still be low at 1 to 2 percent.
It can be cheaper than borrowing normally
When interest rates go down, you may have the opportunity to get loans at lower interest rates. For example, if you have a student loan with an annual percentage rate of return (APY) of 5 percent, you can consider refinancing with a negative APY of 1 percent. This could save you money on your monthly payments by hundreds if not thousands each year.
In a time of negative interest rates, homes may be cheaper and loans may be easier to come by. If you've been thinking about buying a home, you could find great success during an economic downturn. Before making any hasty decisions, it is a good idea to review your finances to make sure it is a good decision in the long run.
Your investments can suffer from the consequences
This can have some negative consequences for the investments you already have. When interest rates go down, so too could your savings be APY. Instead of earning 5 percent APY on your savings, you may be making nothing or worse paying fees for it.
In an ideal world, your savings contributions would earn you interest over time and not burden you. While the US has never had negative interest rates, you should know what those interest rates can mean for your finances. If the economy worsens, there are several savings options you should consider to avoid these fees.
Risks vs. Rewards
The real question is whether negative interest rates could be of use or harm to you. Simply put, we don't know. Since US interest rates have never hit the red, there isn't enough information. But here are some pros and cons of how these rates can affect your wealth.
Pro: Cheaper to borrow. Lower interest rates encourage spending. You may be able to get a loan on a home or car at lower than normal interest rates. With a fixed interest rate, you can save more than usual on your monthly interest payments.
Con: Current investments could suffer. Your investments could cost you instead of making money. For example, your savings stored at a bank may have interest charges and your assets, such as your home, may decline in value.
The central theses
Negative interest rates could earn you money on borrowing while you charge interest on money saved.
If the interest rates are negative, they might not be negative for you. Loans you take out can benefit from low interest rates, but not as low as the state interest rates.
When interest rates are falling, you may have a better chance of getting a loan at a cheaper rate.
The US hasn't hit negative rates yet, but it's always great to learn about the unexpected!
While you may be able to buy a home at a lower interest rate, it is 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 particular investment can cost you in the long run. If you see more positive results than negative results from an investment opportunity, go for it!
sources: Federal Register