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Investors have gotten surprisingly used to negative interest rates. Originally an extraordinary crutch to help economies recover from the supposedly once-in-a-generation catastrophe of the Great Recession, they have become a common feature of the global economy over the past decade.So what does it mean when interest rates turn negative?

How Do Interest Rates Work?

In a negative interest rate environment, lenders pay interest to borrowers. Negative interest rates reduce the principle of the loan over time, and erode the value of funds on deposit. The goal is to encourage lending, borrowing and spending, to help get economic activity moving in the economy once again.

Ordinarily, the lender/borrower relationship works one way. Anyone who borrows money pays the owner for the right to use it over a given period of time. This means that banks pay interest to consumers and businesses who put money on deposit (because the bank uses that money to extend its own loans). It also means that individuals, businesses and governments pay a steady rate of interest whenever they take out a loan themselves.

This simple relationship defines much of the modern financial system.

During a financial downturn, typically lowering interest rates is one of the first ways the U.S. government tries to get the economy moving again. By making it cheaper for individuals and businesses to borrow (and therefore spend) money, the government hopes they’ll be more likely to do so. By reducing the interest paid on savings, the government hopes that people will take money out and spend it.

This generally happens through the Federal Reserve. By reducing the rate at which it lends to banks and at which banks lend to each other, the Federal Reserve can influence interest rates across the board. Per the St. Louis Fed:

“If the economy is slowing, then the conventional response is to lower interest rates, which in turn has two primary effects:

  • Consumption and investment spending increase because the cost of borrowing is lower
  • People saving their money in “safe” places (like deposits at a bank) earn a lower rate of interest and are incentivized to either save less or invest their money in riskier assets that offer higher expected returns. Both of these options would again spur consumption and investment.”

In ordinary times, banking interest rates can’t go lower than 0%. This is called the “zero lower bound.” In extraordinary times, however, interest rates can keep falling.

How Do Negative Interest Rates Work?

Graph showing falling interest rates When interest rates turn negative, this means that lenders have begun actively paying borrowers to take their money. A loan’s interest rate will erode the principle over time instead of adding to it.

This rarely happens, if ever, in the context of consumer-facing loans or business lending. For-profit banks make their money off the interest they charge customers. If a private bank offered negative interest rates on a mortgage or small business loan it would literally be giving money away and would have no income stream.

Instead negative interest happens most often happens in two contexts:

  • Government Lending – The central bank can set the interest rates it charges to a negative value, meaning that when banks borrow overnight funds they ultimately have to pay back less than they borrowed.
  • Depository Institutions – This operates similarly to government borrowing and for a similar reason. Major, typically government, depository institutions will sometimes set a negative interest rate, meaning that if you put money on deposit with this institution it will steadily reduce the value of the funds over time.

In the United States the typical negative interest rate model is depository. The Federal Reserve allows banks to deposit excess cash reserves and it pays interest on those deposits like any other bank. In a negative interest rate environment, the Federal Reserve will reduce this rate (known as the IOER rate) below zero.

This encourages banks to not hold on to these reserves. Any extra cash they keep on hand will be charged away. Even a zero interest loan would be more profitable than actively losing money to negative interest deposits. Per the primer from the St. Louis Federal Reserve quoted above, “all banks have to do to avoid charges from the central bank is use the money they would have held in excess elsewhere.”

Why Charge Negative Interest Rates?

To spur cheaper borrowing.

During an economic slowdown, two things are generally true:

  • Everyone who wants to borrow money at current interest rates has probably already done so.
  • And banks instinctively tighten lending rather than expanding it, in an effort to protect their assets.

Central banks, such as the Federal Reserve, want to change this lending environment. Their goal is to make it cheaper for consumers and businesses to borrow money, so that they can bring in new borrowers and spenders who otherwise would have held on to their savings.

In theory charging negative interest can accomplish this. If the policy works, banks will reduce the interest they charge on loans, since any positive interest rate will beat losing money to a negative rate. More people will borrow money, which they will then spend, helping the economy.

However, this can have unexpected consequences. Most notably, this hurts anyone trying to actively save money. Interest rates particularly affect asset classes considered safe and stable, such as bonds and other debt-backed securities. Lowering interest rates tends to hurt the rate of return on those investments. Households trying to build secure portfolios might lose money in a negative interest rate environment. This can have wide-ranging impacts, from reducing retirement accounts to undercutting consumers who’d been trying to save up for down payments (the exact kind of spending this policy is supposed to encourage).

Government Borrowing

Finally, another aspect of negative interest rates can be government debt. This happens when investors who hold securities, such as Treasury bonds and related assets, receive less back than the face value of the note.

Typically government debt enters negative interest on the secondary market. This means that demand for assets like Treasury bonds has spiked so much that private sellers can charge more than the bond is worth. This reflects investors who so badly want a safe place to keep their money, away from a tumbling stock market for example, that they’re willing to take a loss in exchange for that security.

More rarely, government debt will charge negative interest on the primary market. This happens when the Treasury formally sets the interest on its securities to a negative rating, meaning that investors receive back less than they lent to the Treasury in the first place. As with the Federal Reserve, this typically reflects an effort to spur spending and reduce saving. It means that the Treasury wants investors to take money out of government debt and put their cash into the private market, where it can spur business spending.

The Bottom Line

Negative interest rates are a way for the government to spur lending and borrowing during an economic downturn. By charging (instead of paying) banks interest to put their funds on deposit, the government can encourage those banks to extend loans when they otherwise wouldn’t have. At the same time, there can be serious negative consequences to negative interest rates.

Tips on Saving

  • A financial advisor can build you a financial plan and investment portfolio that keep you secure through times of economic volatility. Finding the right financial advisor who fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
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Photo credit: ©iStock.com/fatido, ©iStock.com/DNY59, ©iStock.com/RichVintage

Eric Reed Eric Reed is a freelance journalist who specializes in economics, policy and global issues, with substantial coverage of finance and personal finance. He has contributed to outlets including The Street, CNBC, Glassdoor and Consumer Reports. Eric’s work focuses on the human impact of abstract issues, emphasizing analytical journalism that helps readers more fully understand their world and their money. He has reported from more than a dozen countries, with datelines that include Sao Paolo, Brazil; Phnom Penh, Cambodia; and Athens, Greece. A former attorney, before becoming a journalist Eric worked in securities litigation and white collar criminal defense with a pro bono specialty in human trafficking issues. He graduated from the University of Michigan Law School and can be found any given Saturday in the fall cheering on his Wolverines.
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