What Are Negative Interest Rates? The Simplest Explanation You Can Find | Exploring Markets

What Are Negative Interest Rates? The Simplest Explanation You Can Find

Some people call it NIRP. That stands for Negative Interest Rate Policy. What does that mean? It's actually more simple than you think. It sounds complicated though because it's such an unfamiliar and untaught concept.

Let's get right to it – here's an example: A bank gives you a loan of $100 at a -2% interest rate. The loan lasts one year. This means that at the end of the year, you owe that bank back only $98. For a $100 loan? Yes, because it was a negative rate. You pretty much got $2 given to you just to take a loan.

But why would someone loan money at a negative interest rate? Two very simple reasons and we will list them below.

  1. Deflation is a major reason and cause for negative interest rates. If a currency like the Dollar is losing value at 5% a year, and you hold $100 in your bank account, then that means that $100 is only worth $95 in the next year. That's because the currency you hold is losing 5% of its value each year.

    This is how deflation works. It can be nasty. It is, essentially, the complete opposite of inflation. Deflation happens when no one is spending and credit is stalling. So, mathematically, it actually makes sense for a bank to make a negative interest rate loan when an economy or currency is deflating. They could make a loan to you for -2%, or let the cash sit in their bank and lose 5%. Take your pick.
  2. The second reason negative interest rates happen is because of Central Banks. They are the organization responsible for the oversight and analysis of a country's currency and economy. The Federal Reserve is the United States central bank, for example. They secure, loan, and take deposits from banks all around the country. If the Federal Reserve is severely worried about deflation, then they will tell banks they can no longer earn money on their deposits at the Federal Reserve. Instead, the Federal Reserve will tell banks that if they try to deposit money, they will do so at a negative interest rate. Think about why that would be effective. Why would banks deposit money at the Federal Reserve if they have to do so at a negative interest rate? They would be much better off loaning that money out to the people at a positive interest rate.

    The purpose is really simple. It may sound absurd or unnatural but deflation is a terrible thing that can evaporate the value of your money and ability to generate more. Enforcing more lending should spur the economy and keep it from stopping. The key is to always spark growth, credit and the flow of money. The Fed is saying: "Hey banks, you can no longer deposit money with us. We need to see more lending and spending. So go have fun! Or else we'll charge you negative rates."