The Federal Reserve recently cut its target interest rate to near 0% as a way to bolster the U.S. economy as it reels from the effects of COVID-19. This lowering of interest rates can make for a great opportunity for real estate owners to save on borrowing money through home equity lines of credit (HELOCs), whether it’s for the purchase of a new property or to rehab an existing property.
As low as 0% interest is, President Trump has even pushed for a further reduction in interest rates, and says he could “get used to [negative interest rates] very quickly.” Although it remains to be seen whether the Federal Reserve will resort to a negative interest-rate policy to help reinvigorate the economy, the U.S. wouldn’t be the first country to adopt these sorts of measures.
So what exactly are negative interest rates and how do they impact real estate investing? We’ll explain that, and then dive into what both 0% interest and negative interest rates could mean for investors looking to take advantage of these low rates with a HELOC specifically.
What are negative interest rates?
Normally, interest rates play in favor of the mortgage lender. They’re used as a way to compensate lenders for the use of their money. Lending money has its risks, primarily that the lender may not receive their money back. So interest rates are a means to account for those associated risks and to incentivize lenders.
Negative interest rates, however, compensate the borrower, not the lender. Why would it make sense to pay someone to borrow money? Primarily to combat economic weakness. Having a negative interest rate is a new concept adopted only in the past decade. The experiment has been undertaken by the central banks of several countries, including the European Central Bank, as well as the central banks of Japan, Sweden, Switzerland, and Denmark.
When interest rates are this low, the idea is that it will encourage consumers and businesses to borrow more money, and, therefore, spend more money. This is all part of the process of trying to grow an economy. Consumers are usually more willing to buy when rates are low, and businesses are in a better position to make the necessary purchases needed to expand. As businesses expand, they tend to hire more people to boost production. This, in turn, increases household wealth, which spurs even more spending.
But although a negative interest-rate policy rewards borrowers, it has a negative effect on savers. This is true for both consumers and banks looking to earn interest on their savings. This is a purposeful move, as well.
In June 2014, the ECB cut its deposit rate from zero to negative territory. The deposit rate is the rate at which banks earn interest on their excess reserves stored with the central bank. This move was a part of a monetary policy aimed at improving economic growth and increasing bank lending. With a deposit rate at -0.1%, banks would be encouraged to lend to businesses and consumers rather than park their money to earn interest in the central bank. If they chose to hold onto their excess reserves, they would have to pay interest instead of earning it.
How negative rates work
Denmark’s third-largest bank, Jyske Bank, may have been the first bank to bring negative interest rates into the real estate market when it began offering mortgages at -0.5% a year in August 2019. Essentially, the bank pays borrowers 0.5% a year to take out a loan. As usual, borrowers make their normal monthly payments, but they ultimately pay back less than they borrow. Because of the negative interest rate, their outstanding balance is reduced each month by more than they paid.
Let’s unpack that a little more in terms of what a negative interest rate would mean if you’re looking to take out a HELOC. Say, for example, you have established significant equity in your home. You have a $350,000 home with a balance of $100,000 on your first mortgage. Your lender offers you a HELOC based on 85% of your home’s value, or $297,500. Because you still owe $100,000 on your first mortgage, you’re able to access up to $197,500 on your line of credit; however, you need only $100,000 to fund the house flip that you’re looking to invest in. Your lender offers you a HELOC with an interest rate of -1% and a 20-year term.
At a -1% interest rate, your monthly payment is $376.21, or $4,514.52 for the first year. The amount you owe after the first year, however, is $94,510.63. This is a reduction of $5,489.37. The difference between what you paid and the reduction in the balance of your HELOC is $974.85, which is just a little less than 1%. This 1% reflects the 1% payment you receive on a declining balance.
To see the savings of a negative interest rate, let’s compare interest rates of -1%, 0%, and the current prime rate of 3.25% (as of Mar. 16, 2020). The prime rate is an interest rate set by the majority of the nation’s largest banks and is used as a benchmark for pricing various loan products. Under normal circumstances, HELOCs tend to track closely to the prime rate.
|HELOC interest rate||3.25%||0%||-1%|
|Monthly payment on a $100,000 HELOC||$567.20||$416.67||$376.21|
|Total interest paid||$36,126.98||$0||-$9,708.42|
This was just a hypothetical situation assuming the lender didn’t charge a markup on the HELOC. Normally, banks charge an interest rate a couple of percentage points higher than the rate set by the Federal Reserve. This difference is known as a spread, and it allows banks to profit from the loan. But even with a couple of percentage points added to reflect the lender’s profit, you can still see how much a reduction in interest rates could save you on your HELOC.
What negative or 0% interest rates mean for HELOCs
There’s no doubt negative or 0% interest rates would make borrowing much more affordable, whether you’re looking to take out your first HELOC or refinance an existing home equity loan or HELOC. Unfortunately, the general consensus is that homeowners and regular real estate investors won’t see mortgage rates drop to zero or negative levels.
But even just a lowering of interest rates can result in real savings and make the available rates for HELOCs more appealing. But real estate investors looking to tap into their home equity should also keep in mind that interest rates will eventually increase again. Most HELOCs have variable interest rates, which means your payments can increase as rates go up. This is important to consider if you’re planning to take out a HELOC.
The short story: The Fed’s move to cut interest rates to near zero should translate into savings if you’re looking to take out a HELOC. But as whenever you borrow money, it’s important to compare rates and take into consideration any associated fees to make sure your HELOC results in saving money over the life of the loan.
If you’re looking into a HELOC to fund your real estate investment project, the Fed’s moves to lower interest rates might make it a great time to borrow money. Keep in mind that there may be an influx of applicants looking at how to get a loan to take advantage of these savings, which could lead to banks increasing rates or denying applications outright to stem the flow.
As always, shop around to make sure you’re getting the best rates on your HELOC. These are interesting times, which could result in big opportunities to save. Only you can determine whether this is a good time to buy real estate for you personally. But make sure to understand the risks of taking out a HELOC and good luck in your real estate investing.