What Are Negative Interest Rates and How Do They Work?

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Updated on Tuesday, August 25, 2020

Instead of adding money to your account, negative rates subtract a percentage, negatively impacting your balance. Typically, when you deposit money into a savings account, you’re used to earning interest, even if it’s not a lot. The money you earn is a result of positive interest rates, which are based off of benchmark rates set by the federal government.

Negative interest rates are also based on rates set by the federal government, and can be used as a tool to help out a struggling economy. We cover how it works, as well as how negative interest rates can affect you.

How do negative interest rates work?

As you may have guessed, negative interest rates occur when the interest rate drops below zero. With a negative rate, a bank or credit union charges you interest to hold your money, subtracting it from your account instead of adding to it. If an interest rate of 0.06% were negative, a $1,000 balance in your account would drop to $999.40 by the end of the year. While your money is still safe, it’s subject to shrinkage.

“Negative interest flips our understanding of interest,” said Ken Tumin, founder of DepositAccounts. “When you deposit money into a bank, you are usually rewarded with interest. Negative interest punishes you if you deposit money at a bank.”

Negative interest is a tool that central banks, like the Federal Reserve, can use as a way to help steer the nation’s economy. The Fed sets the policy interest rate, which is the benchmark for interest rates set by banks and credit unions. Raising and lowering the rate can impact the economy. For example, higher rates encourage people to save by increasing the interest they’re paid on deposit accounts, while lower rates can prompt more spending and consumption by reducing the cost of borrowing.

Creating a negative interest rate is an emergency action that a central bank may take to address an economy that’s at risk or weak. While it sounds like an unusual approach, it can have positive consequences for the economy.

The effects of negative interest rates on the economy

When interest rates are negative, banks have to pay to keep their excess funds in the central bank. By making the rates negative, the central bank is encouraging banks to offer more attractive loan options to lend out their money rather than watching their funds shrink. This gets more money circulating, which in turn can help certain sectors, like retail. Low loan rates can also prompt businesses to invest in capital as well as hiring.

“The thought is driven by central banks trying to fight off recessions like a pandemic,” said Tumin. “The theory is that they want to encourage banks to do more lending, which should help the economy.”

But there’s no guarantee, and ultralow rates could backfire. Mortgages rates, for example, follow the federal funds rate, and banks may become more stringent on lending since negative rates would reduce their profit margin.

Negative interest rates may also cause banks to stop paying interest on deposit accounts. And if banks start to charge customers to hold their money, it may encourage them to pull it out, which would reduce banks’ holdings.

How negative interest rates affect consumers

The ripple effects of negative interest rates can be a slow process, according to Tumin. “If you follow how banks that have negative interest rates started, it’s usually larger depositors being affected first, such as institutional customers,” he said. “The rates slowly trickle down to smaller depositors. It isn’t a fast process when the central bank goes negative.”

Once it does trickle down, though, the impact of negative rates can hit your wallet. Here’s how.

Lower yields on bank accounts – and potentially more fees

The first hit will be to your savings and checking accounts. “Interest rates might not become negative in deposit accounts, but they can become closer to zero,” said Tumin. “Negative rates hurt the profitability of banks, and when banks are hurt they are not consumer friendly.”

In addition to providing low or no yields on accounts, banks will likely add or raise fees, such as monthly maintenance, overdraft, ATM and statement fees. They might also add higher minimum requirements for opening deposit accounts, or they may require a customer to have an active checking account in order to open a certificate of deposit (CD).

Lower rates on loans, including negative rate mortgages

The news isn’t always bad though. Consumers can benefit from negative rates in the form of cheaper loans. Denmark, for example, has had negative interest rates for seven years, and some of its banks are the first in the world to offer negative-rate mortgages.

While negative rates sound like a homebuyer’s dream, analysts predict that they can also drive up housing prices due to higher demand. And banks in Denmark have compensated for their loss in revenue by steadily increasing mortgage fees, which are now about 50% higher than they were a decade ago.

Negative interest rate bonds

Negative interest also shrinks bond yields. When you factor in the interest over the life of the bond, its value at maturity may be less than your purchase price.

In Europe and Japan, both of which have negative interest rates, about 70% of government bonds have a negative yield. You can still make money if you trade the bond, as long as the price of the bond goes higher.

Lower credit card interest rates

Negative interest rates could impact credit card rates by lowering them. Currently, the average credit card charges 14.52%, a rate that has dropped by 0.57% since the first quarter of 2020. Negative interest could continue the downward trend, but it’s unrealistic to expect that you’ll eventually get paid to put a purchase on your credit card.

Are there any countries with negative interest rates?

In 2014, the European Central Bank (ECB) became the first central bank to implement negative interest rates – an action it took to address deflation and the eurozone crisis. At that time, the ECB lowered the deposit rate to -0.1%, and today its current deposit rate is -0.5%, which is the lowest on record.

“In Germany, 80 banks charge negative interest, and 16 of those apply the policy to small depositors,” said Tumin. “A court ruling in June 2018 said banks in Germany can only apply negative interest rates to new customers and not existing [ones]. It’s hard to find positive rates in banks there today.”

The Bank of Japan also has a negative interest rate. It became the first central bank to introduce a zero interest policy in 1999. The country changed its key rate to negative in 2016, in an effort to correct a spike in the yen that resulted from the country’s export-reliant economy. Currently, the rate is -0.1%.

Have negative interest rates worked?

The results of going negative have mixed reviews. Deflation did not vanish in Japan, for example, where core consumer prices fell 0.5% a few months after rates went negative. And lending did not increase as was hoped. Some studies found that bank profits fell in certain European economies and Japan, as many were hesitant to drop deposit rates below zero, which could reduce their funding.

But the ECB reports that the positive effects have included better macroeconomic conditions. This can lead to higher volumes of lending, and an improved economic outlook with better creditworthiness among borrowers, which can lower risk.

How likely are negative interest rates in the U.S.?

The U.S. has never had a negative interest rate. Some lawmakers are currently floating the idea to ensure that the weak growth that lingered after the 2008 global financial crisis, which contributed to the Great Recession, doesn’t happen again.

However, Federal Reserve Chairman Jerome Powell has said he’s not considering it. “I know there are fans of the policy, but for now it’s not something that we’re considering,” he said in an interview in May. “We think we have a good toolkit and that’s the one that we will be using.”

One reason negative rates haven’t yet been adopted is because lawmakers aren’t clear that the Federal Reserve has the legal authority to charge banks interest on their reserves. However, setting the rate at zero could effectively cause negative rates for some types of accounts, such as money market funds, says Tumin.

“You might start seeing some yields go negative, especially next year,” said Tumin. “Money market fund managers have already done it to deposits from certain types of investors, limiting how much money flows into those accounts because of the management fees it costs them. Many are already making some preparations in terms of dealing with that, and it’s possible that we will be seeing a slight negative yield in 2021.”