Ask the CFP: What Are Negative Interest Rates?

Hello everyone and welcome to this month’s Ask the CFP segment. This month’s question is, “What are negative interest rates?” This is a great question and I’ll keep this as high level as I can for today. As a starting point, let’s remember that banks throughout the US can deposit excess cash with the Federal Reserve Bank and earn interest, similar to how you and I deposit money with banks and earn interest. When your local bank has more cash than it’s required to keep, it can deposit funds with the Federal Reserve at an interest rate which the Federal Reserve sets. This is why interest rates on savings accounts, money markets and loans can change when the Federal Reserve changes this key interest rate within the banking system.

If the Federal Reserve lowers this key interest rate, it’s likely an effort to encourage people to borrow money and spend money. If this doesn’t encourage enough economic activity, the Federal Reserve can technically go even lower into negative territory. This means if a bank has excess cash and deposits it with the Federal Reserve, it will cost the bank to do so. It’s the exact opposite of how you and I were trained on loans and savings accounts. Usually savers earn interest and borrowers pay interest. With negative rates, savers would pay interest and borrowers would earn interest. Imagine if your bank charged you an interest rate each month to keep your money in a savings account there. Would you be very excited about keeping your cash in savings? Maybe not, which is exactly the point of negative interest rates. It’s meant to encourage people to spend their money vs. save it. It’s also meant to encourage borrowing, for anything from home improvement to expanding a business.

It’s worth mentioning negative interest rates have been tested in parts of Europe as well as Japan, with mixed results. It’s hard to say if such a strategy is worth it, but luckily the Federal Reserve Bank has, so far, said negative rates aren’t being considered.

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