Why are interest rates so low anyway?
When the economy is in trouble a go to measure is to drive down the interest rates in order to provide easier access to cash for businesses to grow their operations.
By hammering down the interest payments on loans, mortgages and debt the business can put more of that money to work growing the company.
When the economy is up and firing on all cylinders, the central banks can then gradually increase the interest rate to restore a more balanced economy.
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| Photo by Pepi Stojanovski on Unsplash |
Interest rates are lowered to kick the economy into overdrive which over time can lead to inflation, hence why it is important to increase interest rates later on.
How negative interest rates work
One
perception of negative rates is that people might get paid to take out a
mortgage - this is certainly a nice thought, but in reality is an
unlikely situation.
So how does negative interest rates work?
Instead of giving you a negative interest mortgage, the lender would likely give you a relatively low positive interest rate - imagine it as the central bank rate plus the banks commission.
On paper, the everyday individual may not notice the difference between incredibly low interest rates and negative interest rates.
What does negative interest rates mean?
Even before the 2020 pandemic interest rates were low and there were discussions about going negative, including tweets from the then US president Donald Trump.
But why negative interest rates?
Before the 2008 financial crisis the interest rates in the UK and the US were around 5% - this gave plenty of room to lower rates and provide the stimulus mentioned before.
Although this method worked, giving a decade of growth particularly in the US market, the interest rates were not raised enough to provide the same option
The
effects of negative interest rates are that it is intended to stimulate
the economy by providing cheaper money for businesses to loan for
growth and investment.
What does negative interest rates mean for savers?
Negative interest rates on UK savings and in the US have never been seen before and although on paper this might imply savers would pay money to deposit their cash this is unlikely based on other countries that already have negative rates.
The most likely case would be the interest rates would dip slightly below zero, and the banks would just absorb the cost of holding cash to avoid deterring customers.
The banks can still make plenty of cash through various other products on offer, so it makes sense that savers would not necessarily see any direct costs.Although having said that, in case of negative interest rates your money would be better off almost anywhere else other than a savings account anyway.
What do negative interest rates mean for loans?
As far as consumer loans are concerned, banks will always charge a higher interest rate than the central bank rate as this is how they make money.
So the reality is, even if the central bank interest rate was negative, after the bank takes their cut you are back to paying off a positive interest rate again (albeit hopefully lower than before).
This article is not advice and has not been prepared in accordance with legal requirements designed to promote the independence of investment research – no recommendations are given in the buying, selling or holding of any investments. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss. Always seek professional advice.