Negative Interest RateExplained & Defined

When you borrow money from a bank, you expect to make interest payments on top of principal payments.

When you make a deposit in a bank, you expect to receive interest from it.

Essentially, interest is the cost of borrowing money.

For example, you take out a 3-year $25,000 loan from a bank that has an interest rate of 12%.

This means that on top of repaying the $25,000 loan amount, you will have to make interest payments of 12% annually.

Now think of the opposite where a bank pays you to take out a loan instead of you paying interest.

A situation you have to pay a bank to hold onto your cash deposit.

Can you imagine that?

Where a bank pays you to borrow money?

Sounds absurd, right?

But it’s a scenario that happens in the real world.

In fact, central banks in Europe and Japan have already experienced such a phenomenon.

It’s what happens in a negative interest scenario.

So what causes such an unusual scenario to happen?

What necessitates a country’s central bank to employ a negative interest rate strategy?

What does it mean for banks, depositors, and/or investors?

We’ll try to answer these questions as we go along with the article.

What is a Negative Interest Rate?

Normally, you will have to pay interest when you take out a loan.

Also, banks typically pay you interest for depositing your money with them.

However, in a negative interest scenario, the opposite is true.

With a negative interest rate, interest is paid to borrowers.

For example, banks will pay you interest for taking out a loan.

Or that you have to pay interest to deposit money in a bank.

This unusual scenario typically happens during a deep economic recession when monetary efforts have been made and have already pushed interest rates to 0%, yet there still isn’t enough economic activity.

If the country’s central bank wants to further stimulate the economy, it has to go lower than 0%, which results in a negative interest rate.

When a central bank employs a negative interest rate policy, it wants to encourage lending, spending, and investing rather than just hoarding cash.

With a negative interest rate, people don’t have an incentive to keep their cash in banks.

Rather, it hurts them as they have to pay the banks for their deposit.

And who wouldn’t want to get paid to borrow money, right?

But anyways, it’s a rare scenario that only occurs under extreme circumstances.

What happens in a Negative Interest Rate Environment?

During deflationary periods, consumers tend to “hoard” their money rather than spend them.

This is because consumers expect their money to be worth more tomorrow than today.

This results in a scenario where the prices of goods and services drop even lower.

If this lack of stimulation in the economy continues, it can be disastrous for the country.

People may lose their jobs due to employers being unable to pay for them due to a lack of revenue.

A country doesn’t want that to happen.

And so, in such an extreme situation, its central bank (or other regulatory body) may implement a negative interest rate policy (NIRP).

It’s a situation where even a 0% interest rate won’t cut it.

With a negative interest rate policy in place, people are incentivized to take out loans as they get paid for doing so (rather than being the ones to pay interest).

Also, people are penalized for keeping their money in banks.

This is because they have to pay interest for their deposit.

Hopefully, with the introduction of a negative interest rate policy, consumers are more inclined to spend or invest their money.

After all, who want to keep their money in the bank when they could potentially profit from borrowing instead?

Banks are not exempted from this either as negative rates affect them too.

With the increase in economic activities, the country’s economy will be revitalized.

But well, that’s how it should work in theory.

The Consequences of Negative Interest Rates

While in theory, a negative interest rate policy should stimulate the country’s economy, it’s still not really clear if that’s the case in reality.

Look at the flip side, it may incentivize people to borrow, but what about the lenders?

Lenders want to be compensated for lending their money to potentially risky borrowers.

Lenders also primarily make profits from collecting interest.

Take that away from them, and what do you think would happen?

A negative interest rate policy would ultimately deter these lenders from lending more money as doing so would mean losses for them.

This could needlessly slow down the economy. It has already happened in countries that have a negative interest rate policy in place.

On the bright side, there are cases where a negative interest rate yielded positive results.

Particularly in Switzerland, borrowers may be able to take out a loan with a modestly negative interest rate.

So maybe a negative interest rate policy can work in moderation.

Another possible consequence of negative interest rates: consumers will take out their deposits in banks and just keep them within their premises (such as under the mattress).

It happens when the interest rate is at 0%.

What more if the interest rate becomes negative?

And there’s no assurance that these consumers will spend or invest the money.

Another concern is that shaking off or reversing the negative rate cycle once it begins isn’t that easy.

Countries that implemented negative interest rates are still in the negative zone, even if the recession ended more than 10 years ago.

And there’s no conclusive evidence that the economic situations of these countries are better than they were before the implementation of a negative interest rate policy.

What do Negative Interest Rates Mean for You?

In most cases, negative interest rates only apply to bank reserves that are held by the central banks (or in the US, the federal reserve’s).

They rarely trickle down to the consumer level. So even if your country might be employing a negative interest rate policy, you might not experience it firsthand.

However, in the case where negative interest rates become widespread, we can think of the consequences that involve the general consumers.

First, those who have deposits or wish to deposit in a bank will have to pay fees just to keep their money there.

Rather than earning interest from saving, savers will pay interest instead.

On the other hand, borrowers would get paid for borrowing rather than paying.

In theory, this should incentivize people to borrow money and profit from it.

People are discouraged to hoard money as doing so will penalize them.

Rather, savers are encouraged to spend or invest their money.

This increase in economic activity will help in revitalizing the country’s economy.

Should savers still want to keep their money, they have to do so within their premises.

However, they lose the security that banks can provide.

This exposes the money to a higher risk of theft.