Too embarrassed to ask: what are negative interest rates?

YouTube

Watch On

There’s been a lot of talk from the Bank of England recently about introducing “negative interest rates”. So what on earth are they, and what would they mean for your money?

Usually, if you lend money to someone, you expect them to pay you the money back, plus interest. This is why your bank pays you interest on your savings – technically, you are lending your money to the bank. Interest rates are usually positive with good reason. After all, why would you pay someone else for the privilege of lending them money?

Nevertheless, several countries now have negative interest rates. For example, the European Central Bank’s main interest rate is currently minus 0.5%. Negative rates turn the financial world on its head. If a borrower borrows at a negative interest rate, they end up paying back less than they originally borrowed. In other words, savers are charged to save, and borrowers are paid to borrow.

MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

So why would a central bank impose negative rates? The theory is that if savers are charged to save money, they will spend rather than save. In turn, that will encourage more economic activity and growth. In practice, it’s not at all clear that this is what happens. Indeed, some argue that negative rates have the opposite effect.

For example, rather than spend money, savers might just save even harder to compensate. And rather than invest in new capacity, companies might view negative rates as a sign that the economy is in dire trouble, and focus on using cheap borrowed money to buy back their own shares instead. On top of that, any companies with pension liabilities will find that those liabilities balloon as interest rates fall ever lower, which also discourages investment. Of course, none of this will necessarily prevent central banks in the UK and perhaps even the US from following their European counterparts into negative territory.

So far at least, negative rates only affect big institutional savers. Banks are not yet passing negative rates onto small depositors like you or I – although more might start charging for current accounts, which amounts to the same thing. Sadly though, you’re unlikely to get a negative interest rate mortgage.

For more on how all of this might affect your investments, subscribe to MoneyWeek magazine.