As the Federal Reserve slashes interest rates to boost the economy, consumers and people into real estate investing are asking what this means for them. Low interest rates offer an exciting opportunity to purchase real estate and refinance existing debt at a reduced cost. But what does a 0% interest rate mean for mortgages and the ability to borrow? And what if the interest rate goes into the negative?
Here’s what you need to know about what 0% or negative interest rates mean for mortgages.
- What is a negative interest rate?
- How negative interest rates work
- What negative or 0% interest rates mean for mortgages
- How does the interest rate situation affect banks and loan availability?
- Should you refinance your mortgage when rates decline?
- Bottom line on negative or 0% interest rates
What is a negative interest rate?
In normal circumstances, when a borrower takes out a loan, they pay back the original loan amount plus interest over time. The interest rate is based on the lender's costs, the risk profile of the borrower, and an expected profit margin.
Negative interest rates upend the normal loan process. Instead of the bank receiving the full loan balance plus interest over the life of the loan, the bank actually receives less money back than it originally lent the borrower.
This doesn't mean your loan is free. You'll still need to make loan payments for the term of your loan. However, instead of interest being added to your principal balance payment, it is subtracted from it.
Why use negative interest rates?
The Federal Reserve uses monetary policy to influence the availability of money and cost of credit to promote a healthy economy and control inflation. When the Federal Reserve feels the economy is slowing or there is financial uncertainty, it will lower interest rates to stimulate the economy. Lower borrowing costs encourage banks to borrow from the Fed and then lend to customers.
In Europe, interest rates for some countries have approached zero or gone negative long before the U.S. dramatically reduced interest rates in March 2020. As of March 2020, there are five countries around the world with zero or negative interest rates:
- Switzerland: -0.75%
- Denmark: -0.60%
- Japan: -0.10%
- Sweden: 0%
- Spain: 0%
The U.S. is now also an honorary member of this infamous club. The Federal Reserve Federal Funds Rate was set to a range of 0.0% to 0.25% on March 16, 2020.
How negative interest rates work
Negative rates work in the opposite way standard interest rates work. When you deposit money at the bank and your savings account has a negative interest rate, then you pay the bank each month to be a safe haven for your money. Over time, your deposit balance will actually shrink.
On the flip side, borrowers are paid to take out loans because the total of their loan payments is less than the original loan balance. A traditional mortgage requires payment of both principal and interest. The longer the term of the mortgage and the higher the interest rate, the more interest you will pay over the life of the loan. Negative interest rates flip this model on its head.
With a negative interest rate, the amount you pay each month is less than a traditional mortgage payment. In fact, when you add up all the mortgage payments you make over the term of the loan, you'll pay back less than you originally borrowed.
In the table below, you'll see the monthly payment for a 30-year $200,000 loan at various interest rates. Notice that with the -1% interest rate mortgage, the borrower pays back less than the original loan amount.
|Monthly loan payment||$476.15||$555.56||$643.28||$739.24||$843.21||$954.83|
|Total amount paid||$171,414.00||$200,001.60||$231,580.80||$266,126.40||$303,555.60||$343,738.80|
What negative or 0% interest rates mean for mortgages
From a borrower standpoint, 0% or negative interest rates seem like a good idea. The lower the interest rates go, the more money you can save in interest payments. Thus, many people wonder how to get a loan like this. However, low rates can affect your ability to get a loan as banks also have less incentive to lend since their potential profits are reduced.
Pros of a negative or 0% interest rate
When interest rates are low, it encourages consumers and businesses to borrow money. They may buy more items on credit or make a larger purchase, such as a home. This is also an excellent opportunity to refinance high-interest debt. With a reduced interest rate, you can borrow more for the same payment, or you can borrow the same amount for less each month and free up space in your monthly budget.
Zero or negative interest rates make purchases attractive because the cost to borrow is so low. This is especially true when borrowing costs are lower than the rate of inflation. This spending stimulates the economy and creates demand for goods and services. Why keep your money in the bank if it will be worth less tomorrow? Instead, most people will spend the money or invest it in other assets earning a better interest rate.
Cons of a negative or 0% interest rate
When interest rates are low or negative, it creates artificial demand. Consumers and businesses buy goods and services they otherwise may wait to purchase. This increased demand can lead to inflation because there are now more buyers for the same amount of goods.
When rates are reduced because the economy enters a recession and layoffs start happening, banks may also become hesitant to lend. Banks will typically make it more difficult to borrow if they are concerned about their borrowers' ability to repay those loans. Additionally, banks want to ensure the asset backing the loan will maintain its value. For example, if your house is put up as collateral, they want to make sure your house maintains enough value for them to recoup the cost of their loan if you default.
As interest rates decline, banks also lower the interest rate paid on deposit balances. When this happens, you will earn less interest on your checking, savings, and money market accounts. A formerly high-yield savings account may become less lucrative. And when certificates of deposit mature, the renewal options usually offer lower rates than before.
How does the interest rate situation affect banks and loan availability?
When the Federal Reserve changes interest rates, there is no direct impact to mortgage rates. According to Casey Fleming, a mortgage adviser and author of The Loan Guide, "Mortgage lenders consider three factors when setting rates: cost of funds, capacity, and competition."
- A mortgage lender's cost of funds is based on the yield of mortgage-backed securities. In other words, the rate that institutional investors demand to invest in pools of mortgages.
- Capacity is the ability of a mortgage company to process loan applications and fund loans. When lenders have excess capacity, they'll lower rates to encourage applications and raise rates to discourage them.
- Lenders have competition in the form of other mortgage companies who are also trying to attract borrowers. This is true even if the profitability of loans is less than its desired level.
As interest rates decline, banks and mortgage lenders tighten their underwriting criteria to reduce risk. The best mortgage lenders may require higher credit scores or larger down payments to protect themselves against default. Additionally, your supporting documents may undergo more scrutiny by underwriters as they evaluate your loan application.
In April, JPMorgan Chase increased its underwriting standards now require a minimum FICO score of 700 on purchase mortgages. Plus, borrowers must also have a down payment of at least 20%.
The nation's second-largest mortgage lender, United Wholesale Mortgage is also changing its loan application process. Regulatory guidelines require lenders to verify income and employment within 10 days of loan closing. United Wholesale Mortgage is taking this a step further. It now requires reverification of employment on the date the loan is supposed to close. This protects the lender by making sure there have been no changes in your employment situation since you've submitted your application.
Fannie Mae and Freddie Mac change the age of document requirements from 120 days down to 60 days. Now, your income and asset documentation (e.g. pay stubs and bank statements) have to be more recent. These documents must be dated within 60 days of the mortgage note.
Should you refinance your mortgage when rates decline?
Most people would consider it a good idea to refinance your mortgage to reduce their interest rate when current rates are lower than their current rate. However, you should still ask your potential lender all the important mortgage questions, plus there are several specific factors to consider before submitting your loan application:
- Reset the clock on your mortgage. When you refinance, the clock starts over when it comes to your repayment period. A longer payment period could erode any savings from the new interest rate. Consider refinancing into a new 10-, 15-, or 20-year loan instead of a 30-year.
- It costs money to refinance. Loan expenses can include origination fees, appraisal costs, title insurance, and more. Plus, you'll need to fund your escrow account with prepaid insurance and property taxes. You might be able to include these costs in your loan amount or increase your interest rate to receive a credit to offset these costs.
- How long will you be in the home? Refinancing can make sense if you'll be in your home for several more years. If you're unsure, you may be better off paying extra each month on your current loan. By paying the equivalent of one extra payment each year, you'll knock more than four years off a traditional 30-year mortgage.
Bottom line on negative or 0% interest rates
The current circumstances could lead to a good time to buy real estate. And borrowing when rates are at 0% or even negative presents a great opportunity to save money on interest. You can buy a new property or refinance an existing loan at a much lower rate. This reduces your interest costs and provides you with extra money every month versus when interest rates are higher. You can use the money to save for your future, accelerate your debt payoff, or pay other bills.
To increase the chances of getting your loan application approved, improve your credit score, have extra money in the bank as reserves, and be able to document your income.
Although it can be enticing to borrow more money because interest rates are lower, borrowers need to understand their finances so they don't take on too much debt. This is especially important if the loan has a variable interest rate. As the economy recovers, your interest rate will rise and your monthly required payment will also increase.