What Are Negative Interest Rates And How Do They Affect You?

Imagine a time when a bank will pay you to take out a loan and where you need to pay the bank to hold onto your cash. No, it’s not a made-up scenario: it’s what could happen when there are negative interest rates.

We’ve already seen parts of Europe and Japan experience this. While negative interest rates may come with some benefits, they might end up causing more problems down the road.

So what are negative interest rates and how do they affect you? Let’s take a look at how they work and the impacts on borrowers, investors and savers.

What Is A Negative Interest Rate?

Negative interest rates happen when an economy’s interest rates drop below zero. Under negative rates, commercial banks pay storage fees to the central banks instead of receiving positive interest income.

Interest rates can go negative from Treasury securities, yields on bonds or the Federal Funds rate. The latter is the Federal Reserve’s main way to help guide the economy, whether it’s to help increase or slow down growth.

The federal funds rate acts as a benchmark for borrowing rates. That means when the Federal Reserve raises the rates, it can slow down borrowing since it’s more expensive to take out loans. When it’s lowered, the aim is to boost the growth of the economy since it becomes less expensive to take out loans. In other words, lower interest rates may encourage banks and consumers to take on more risk by lending and borrowing money.

How Do Negative Interest Rates Work?

Negative interest rates encourage people and businesses to borrow and spend money, which helps to stimulate the economy, especially during a recession.

Think of negative interest rates as turning the banking world upside down. Instead of a bank paying you interest to hold your money, you may have to pay them instead. In addition, bond yields may also end up having negative interest rates, meaning that investors will earn less money than they initially invested.

For borrowers, negative interest rates may work in their favor as they’ll pay less in interest to the lender for the loan.

Consequences And Risks Of Negative Interest Rates

In theory, negative interest rates can help to boost the economy. However, many experts suggest that negative interest rates won’t lead to the types of economic growth that the U.S. or other countries hope for. In fact, it raises concerns about bank profitability if implemented.

For one, lending institutions are in the business of making a profit. It makes sense they want to be able to earn money to loan out, especially to borrowers who are considered high-risk. What this means is that lenders may restrict loans to those with lower credit scores to mitigate that risk. This in turn would make it harder for borrowers to be approved for loans, negating the intent of growing the economy.

Since negative interest rates will drastically lower bank profit margins, it could end up slowing the economy even further as lenders feel deterred to lend to more borrowers, even those who are low-risk.

In addition, banks may not want to keep their deposits at the Federal Reserve due to negative rates. It could strain the financial system if banks end up converting their reserves into currency. There’s also a valid concern that consumer financial products that have negative interest rates may cause bank runs. Instead of keeping money at banks, consumers would rather hold their cash, where a zero interest rate is better than a negative one.

These types of consequences can be long lasting, even if interest rates come out of the negatives. Combine this with the fact that there isn’t ample evidence that negative interest rates help the economy, and it makes sense that the Federal Reserve is wary about it.

How Negative Rates Would Affect You

Negative interest rates may not happen in the U.S. anytime soon, if at all. However, in the event it does happen, here are some of the ways negative interest rates could affect you:

• Loans and mortgages: Loans and mortgages may be harder to qualify for, especially for those with fair and low credit scores. This means you’ll need to ensure your finances are in tip-top shape to take out a loan. Even though you could get a loan or a mortgage with a lower rate, lenders may impose additional fees to make up for the lowered profit margin. Also, lower rates could drive up demand for homes, driving up property prices.
• Credit cards: Though it’s highly unlikely credit card issuers will pay you to use your credit card, negative interest rates could mean your card’s interest rate will go down.
• Savings accounts: Any earnings you could potentially earn, especially on high-yield savings accounts, would go down drastically. Those who have a lot of cash on hand will suffer the most, since they may have to pay the bank to hold their money.

Do Negative Interest Rates Make Sense?

Negative interest rates make sense as a tool to encourage growth during dire economic times. In combination with regulations that minimize the potentially long-lasting effects, the concept could work. However, there isn’t enough evidence that it will, nor is it likely that the Federal Reserve will look to lower rates even further anytime soon.

Still, it’s a good idea to understand how it will affect you and learn about ways to continue to do well in your financial life. Want some extra help staying on top of your expenses? You can easily create and track your budget using Rocket Money, now available on mobile app or web. Rocket Money will even scan your expenses for you and negotiate bills to help you save.