We are now almost a decade into a world of low interest rates, and in some countries, interest rates have even become negative, which was unheard of previously. Let’s go over exactly what negative interest rates mean, how we got here, and what that means for your investments.
What exactly are negative interest rates?
Interest is what someone pays to borrow your money. So a negative interest rate is when you have to pay someone to borrow your money. That, of course, begs the question “Why on earth would anybody do that?”
Well, first, let’s review nominal interest rates, inflation and real interest rates quickly.
Nominal interest rates are measured in money. For example: you lend someone $100 and at the end of the year someone pays you $100 plus $2. That’s a 2% nominal interest rate. But money can lose value over time – or in other words goods and services (apples, say) can become more expensive. That’s inflation. Now, real interest rates are measured in goods. They tell you how many more apples you can buy with your money at the end of the year, having lent it, than you could at the beginning of the year. So say the price of everything increased by 5% in that year. Well, your real interest rate would be roughly 2% – 5% = -3%. So you would have effectively paid someone to borrow your money. Even though you will have more pounds at the end of the year, you can buy fewer apples than you could at the beginning.
So it’s easy to see that if inflation is higher than the nominal interest rate, real interest rates can be negative. And it’s easy to see why, even in that case, there would be some lending – even though you are getting poorer in terms of apples, you are still a little better off lending than leaving your money under the mattress.
But the interesting thing is that in some countries even the nominal interest rates have become negative. Hmm, now how did that happen?
Why are there negative interest rates?
Nowadays interest rates are typically portrayed as the controls on a thermostat for the economy: if consumption and investment are weak, a rate cut makes it easier for consumers and companies to borrow, hopefully driving consumption and investment back up.
So why not drive the interest rate as low as possible in order to give the economy the biggest possible boost, you might ask? Well, if interest rates are too low, traditional economic theory went, the excessive investment and consumption causes inflation. Think of crowds with bursting wallets looking to buy apples. But with only so many of them to go around, Braeburns are soon being auctioned off for small fortunes to the highest bidders.
But it turns out that low interest rates don’t always cause such growth, frenzy and inflation. Japan had discovered this in the 90s, but was generally regarded as an exception. So, when in the wake of the Global Financial Crisis the US, UK and European central banks started cutting rates, they cut a little, and a little more, and a little more, all the way down to zero in the hopes of keeping economies afloat. This was called ZIRP – Zero Interest Rate Policy.
Zero interest rates are one thing. But what about negative interest rate policy?
Well, because certain types of companies, like insurance companies, banks and certain funds, must hold government bonds, it’s easy enough for central banks to make the rate negative: they have captive buyers. And that’s what some central banks have done, in an attempt to provide yet another boost to the economy and inflation.
Negative interest rate countries include Sweden, Denmark, Switzerland and Japan. In Sweden, for instance, banks must pay a rate of -1.25% to deposit their funds overnight with the central bank. The Japanese central bank charges banks -0.1%.
Now, the catch is that there’s no reason for the bank give you, as an individual, a negative interest rate on your loans. The government can induce them to pay to lend, but you can’t.
Yes, there have been a few curious exceptions. In some cases, loans that were taken out before rates were so low were indexed to certain government benchmark rates, and as the government rate went negative, so did the rate on that private loan. Those cases caused confusion: in some it was determined that the bank did in fact owe the borrower ‘negative’ interest, whereas in others courts decided that interest is only payable from borrower to lender, so negative interest equals zero interest. But those are the exception.
Sorry – it’s not very likely that someone will pay you to take their money via negative interest rate loans, mortgages or bonds.
What do negative interest rates mean for my finances?
Still, there are important implications for your finances. Governments are usually considered the safest borrower for a bank, and therefore pay the lowest rates. Everybody else pays something above that rate. With government rates going negative, the rates for everybody else come down too, even though they don’t go below zero.
On the other hand, because they aren’t lending at very high rates of interest, banks aren’t willing to pay depositors much either. In fact, on that side, because they have to cover their overheads, they may even try to charge their depositors negative interest, especially once fees are taken into account. So it’s then up to you whether to pay the bank to hold your money, or take it out and find somewhere else to put it.
So right now is basically an excellent time to borrow, and a relatively poor time to invest in safe interest-earning investments such as saving accounts. If you are looking to buy property, or start-up a business venture, now might be a good time to secure a mortgage or business loan.
But remember – interest rates also affect property prices. Current low rates are one reason why property prices are generally high. If rates increase, prices may fall. And if you have a mortgage with a tracker rate that rises as interest rates rise, while the price of your property falls, you are likely to find yourself in trouble. So make sure you have a sufficiently long fixed rate on your mortgage, and price in some amount of interest rate rises in your forecasts.
On the other hand, you need to make sure you are doing your best to make a good return on your savings. You can shop around for the best rates and lowest fees, or discuss with a financial advisor what other classes of investment, or what countries, offer better financial returns.