Understanding Negative Interest Rates

Time To Read 3 MIN READ

Negative interest rates are a peculiar thing. They are the rate of interest you earn when you invest in instruments like bonds or a savings account at your local bank. Not only do you not earn money when interest rates are negative, but you might actually owe it. The situation is unusual, so many investors don't understand exactly what a negative interest rate is or how it can come into play.


The Basics of Negative Interest Rates

A negative interest rate is the opposite of a positive – or regular – interest rate. Banks typically pay interest to people or institutions that deposit money with them. If you open a savings account with a $1,000 deposit, you might end the year with a balance of $1,010. With a negative interest rate, you'll be charged for the privilege of having the bank hold your money. The $1,000 you originally deposited might only be worth $990 at the end of the year.


Causes of Negative Interest Rates

Banks are understandably reluctant to offer negative interest rates to customers. Not many investors are willing to pay a bank to hold on to their money, at least under normal circumstances. However, banks are economic institutions and they are subject to the economic realities of the countries in which they operate. The central banks that dictate a country's monetary policy can implement negative interest rates to help prevent deflation, where prices are falling rather than rising. Deflation is often a reflection of a stagnating economy, so central bankers will do what they can to stimulate economic growth. Central bankers also use negative interest rates to incentivize banks to invest their excess deposits rather than simply sitting on them.


Benefits of Negative Interest Rates

With negative interest rates, borrowing costs for consumers and businesses fall. This often triggers loan growth and economic expansion. Negative interest rates also tend to lower the value of a country's currency. When the value of a currency falls, the products the country exports become cheaper to buyers in other countries with stronger currencies. For example, if the Canadian dollar falls in value from 90 U.S. cents to 60 U.S. cents, goods and services in Canada become dramatically more affordable for American buyers. This can result in additional buyers flocking to Canada, triggering growth in exports and jobs.


Dangers of Negative Interest Rates

Negative interest rates certainly aren't helpful to savers. One of the prime dangers of negative rates is that individual investors will keep their money at home rather than deposit it with a bank. Banks become more susceptible to financial collapse with fewer deposits. Negative interest rates also lower the amounts that banks can charge on other types of loans, such as credit cards and car loans, further reducing their profit margins.

In an extreme negative interest rate environment, consumers may end up being paid to take out traditional loans, such as a home mortgage. In that scenario, speculation is likely to take hold because investors can earn money through borrowing. With an increase in speculative investing, bubbles are likely to form, possibly wreaking havoc on the economy when they ultimately burst.