How can negative interest rates impact your finances?

Here’s what you need to know about negative interest rates.
Bank of England | Wealthify
Reading time: 6 mins

With the current pandemic and economic recession, discussions around the Bank of England cutting interest rates to 0% or even going negative have multiplied. But what would happen if interest rates were to fall further? How would savers be impacted? Here’s what you need to know about negative interest rates.

 

What are negative interest rates?
Before we talk about negative interest rates, it’s important to understand how interest rates work. If you’re saving in a cash savings account, you would expect to earn interest on your money – and how much you get depends on the interest rate set by your bank or building society. Obviously, the higher the interest rate, the better it is for your savings. Interest rates can be fixed for a set period of time, or they can fluctuate , meaning your money could grow at a different pace one year to another – these interest rates are known as floating or variable rates and they come with more uncertainty since the rates aren’t guaranteed.

When setting their interest rates, banks consider the base rate, also known as the Bank Rate. It’s essentially the interest rate that the Bank of England (the ‘mother’ of all banks in the UK, if you want) will lend to other banks at , and it ultimately serves as a basis for all other interest rates in the country. Back in March 2020, the Bank of England cut its base rate at 0.1% and it hasn’t changed since1. However, with Covid-19 infection rates increasing once more, there is concern that the economic impact of various government support measures will last several years. There has been speculation that the Bank of England may consider cutting its base rate from 0.1% and introduce a negative base rate2 .

But why, you ask? Well, setting a negative base rate would push banks to reduce their interest rates and the reasoning behind this is that it’d encourage people to save less, potentially borrow more and increase consumption and investment. Think about it, when you borrow money, you have to pay interest on your loan, and in this case, the lower the interest rate is, the cheaper your loan would be. Even better, with negative interest rates, the bank could pay you to borrow – it may sound crazy, but it can happen as was the case in Denmark in 20193 .

So, here negative interest rates would be used as a way to boost economic demand in the economy which has slowed down since the start of the pandemic. It’s just another tool the Bank of England can use to stimulate consumption and the economy – but one thing to note is that it does remain quite an unusual practice and banks can be reluctant to introduce negative interest rates. Now, 2020 has been peculiar, so who knows? It’s always safer to prepare for all kinds of scenarios, and if you’re saving, then you may want to know how your pot of money could be impacted.

 

What could negative interest rates mean for your savings?
Put very simply, negative interest rates would penalise savers. As mentioned above, the higher interest rates are, the faster your savings would grow. However, if interest rates were to be negative, then you wouldn’t see any growth on your savings. Theoretically, banks could even charge savers for depositing their money, but it’s rarely done in practice. The worst that can happen, if you’re saving, is that your bank would stop paying interest to you and your savings would actually decline, as is the case in some German banks.4

Now you may not find the situation worrying in the short term, but assuming over time, that the cost of living, or inflation, increases, your savings would see their real value decrease. What this means is that in say 10 years, with the same amount, you won’t be able to afford as much as you could a decade ago. To enjoy real growth, your money needs to grow at least at the same pace as inflation, but with negative interest rates, your savings are unlikely to keep up with the rate of inflation unless that is also negative.

 

Why consider investing?
If you want your money to grow over the long-term, then you may want to consider other options where your money isn’t tied to any interest rates. And that’s exactly where investing could help. By putting your money in the stock market, you could potentially end up with inflation beating returns – obviously, since your returns aren’t dependent on any interest rates, there’s also a risk you may end up with less than you initially invested.

The good news is that historically stocks have almost always beaten cash over the long-term. According to a Barclays Equity Gilt Study, stocks kept for any 10-year period since 1899 have had a 91% chance of outperforming cash5. The other good news is that investing in the stock market could potentially provide you with a rate of returns that exceeds the rate of inflation. Since 1983, the FTSE 100 has returned about 6.2% a year (with re-invested dividends) – this sits well above the average inflation rate in the UK (RPI) which is set at 3.4%6. One thing to note though is that past performance, although insightful, is not a reliable indicator of future results, and performance could go up as well as down over time.

Obviously, as times are more uncertain than usual, the value of your investments can be expected to fluctuate more than typical, especially over the short-term. But that’s normal, markets are a bit like roller coasters and if you decide to invest, it’s important to learn to live with these unpredictable movements (called volatility). And luckily, there are ways to ride the bumps. For instance, by remaining invested over the long-term and spreading your money across assets (e.g. shares, bonds, and property) and regions, you could diversify your investment risk.

And if you want to maximise your potential returns, why not open a Stocks and Shares ISA? Investing in an ISA could help you keep more of your money as you don’t need to pay tax on your returns. Or, if you’re comfortable having your money locked away until your 55th birthday, then it could be worth having a look at personal pensions, also known as SIPPs (Self-Invested Personal Pensions). The advantage of having a personal pension is that you’ll get 20% tax relief on each contribution you make, or for every £800 you put in your pot, the government will add £200 – what’s not to love? Although it’s possible to invest tax-efficiently, it’s important to remember that tax treatment depends on your personal circumstances and financial situation, and may be subject to change in the future.

Whether you want to open a Stocks and Shares ISA or a personal pension, you don’t have to do it all on your own if you don’t feel like it. Robo-investors, like Wealthify, will do the hard work for you – we’ll build and manage your investment Plan, based on your investment style, from Cautious to Adventurous. And our team of experts will make adjustments, when needed, to ensure you benefit from any opportunities that arise.

 

References:

1: https://www.bankofengland.co.uk/monetary-policy/the-interest-rate-bank-rate

2: https://www.bbc.co.uk/news/business-54506853

3: https://www.theguardian.com/money/2019/aug/13/danish-bank-launches-worlds-first-negative-interest-rate-mortgage

4: https://moneyweek.com/518525/german-banks-are-now-charging-savers-could-it-happen-here

5: https://moneyweek.com/505257/stocks-beat-cash-and-bonds-over-the-long-term

6: Data from Bloomberg:

FTSE as stated 6.21% annualised from 31/12/1983 to 29/10/2020

UK RPI from 31/12/1983 to 30/9/2020

 

Past performance is not a reliable indicator of future results.

 

The tax treatment depends on your individual circumstances and may be subject to change in the future.

 

Please remember the value of your investments can go down as well as up, and you could get back less than invested.

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