What Is a Negative Interest Rate?

A negative interest rate is a rate of interest on an investment, loan, or similar financial instrument that falls below zero. This may occur when a nominal interest rate drops below the inflation rate; it is very rare for the real interest rate to be set at a negative number, but it can happen. For lenders, there are significant disadvantages to this, as it means they take a loss, rather than a profit. Borrowers may benefit, and lowering interest rates can create an incentive to borrow, which may spark economic activity.

It is important to understand the difference between nominal and real interest rates. A real interest rate is much like it sounds, but a nominal rate is corrected for inflation. If inflation is at 6% and interest is set at 8%, the nominal interest rate is 2%. If a borrower takes out a $100 United States Dollars (USD) loan for a year, she will need to repay $108 USD at the end of the year. Inflation, however, means that $100 USD a year ago is actually $106 USD now, so the borrower has only paid $2 USD in interest. It is the interaction between inflation and nominal interest rates that can create a negative interest rate.

Federal agencies in charge of setting an interest benchmark consider inflation when they raise or cut interest rates. They usually want to keep the nominal interest rate above zero, and thus are careful to put the real interest rate at least a quarter of a point above the inflation rate. If inflation is at 4%, for example, an interest rate cut might go to 4.25%, but it would be unlikely to drop to 4%. If the rates were slashed to 3%, the result would be a negative interest rate; on that $100 USD loan, the borrower would repay $103 USD, but the original loan would be worth $104 USD, and the lender has just lost a dollar.

Very low interest rates can stimulate economic activity. A negative nominal interest rate may appeal to borrowers, who have every reason to take out loans at that rate because they will actually profit on the loan, as the lender essentially passes interest back to them. Lenders, naturally, have no particular desire to pay people to borrow money, and they can respond to falls in interest rates by tightening lending restrictions and taking other measures to make it harder to get a loan.

Some economists suggest that a negative interest rate can be used as a penalty for holding on to cash to encourage banks and other institutions to make loans. In a theoretical example, a central bank could decide that each year, it would cancel out 10% of the existing currency; any institution holding cash would lose 10% of its value. In this situation, lending at a negative interest rate would be appealing, as the loss would be lower than that created through the currency adjustment scheme. There are considerable regulatory barriers in the way of such plans, but they can be an interesting topic of discussion in theoretical conversations.