Does a 0% or Negative Interest Rate Mean You Should Refinance?

As you may have heard, the Federal Reserve slashed its benchmark interest rate to zero in mid-March 2020 as a part of an emergency measure to bolster the U.S. economy in the face of the coronavirus pandemic. If you’re looking to refinance your home, refinance a rental property, or take advantage of refinancing opportunities for your real estate investing, what could be better than paying 0% interest, right?

Any time interest rates drop, it becomes more affordable to borrow money. Whether it’s to refinance an existing property or get a loan to fund a flip, taking advantage of lowered interest rates can save you money over the duration of your loan.

However, although the Federal Reserve cut its federal funds rate to zero (the interest rate at which banks lend and borrow money from one another), that doesn’t mean you’ll personally see 0% mortgages anytime soon. Before we discuss what 0%, or even negative, interest rates mean for refinancing, let’s explore what negative interest rates are and why they happen in the first place.

What are negative interest rates?

Simply put, interest is the cost of borrowing someone else’s money. People have been paying to use someone else’s money for thousands of years. But for most of history, interest rates have been greater than zero, or positive. Positive interest rates compensate lenders for the use of their money and help account for the associated risks of lending money out to strangers.

In recent times, particularly following the 2008 financial crisis, several countries began to experiment with negative interest rates as a part of their monetary policy. This move was first undertaken by the European Central Bank in 2014, followed shortly thereafter by Japan. The central banks of Denmark, Sweden, and Switzerland have also experimented with negative interest rates.

Although negative interest rates can occur in effect if the rate of inflation outpaces the return on savings or loans — for instance, if inflation is 4% and the interest rate on a loan is 3%, the lender’s return after inflation will be less than zero — central banks have begun intentionally using negative interest rates as a way to reinvigorate weak economies. The ECB’s key interest rate, for example, was pushed further below zero in September 2019 amid renewed signs of economic weakness. The ECB’s key rate is -0.5% as of April, 2020.

Under a negative interest rate policy, banks are discouraged from parking their excess cash with the central bank because the negative rate means they would have to pay interest on that money. If a central bank adopts this measure, it’s usually in the hope of encouraging banks to move their money out of savings and increase their lending to businesses and consumers. The idea is that if businesses and consumers have more money to spend, it will encourage economic growth. Even when these banks charge a higher rate on the money they’re lending because the federal funds rate is set at 0% or negative, the consumer is still getting an incredibly low interest rate, and the lending bank is no longer losing money.

How negative rates work

The idea of a mortgage with a negative interest rate may have you scratching your head. To better understand how negative interest rates work, let’s explore what the federal funds rate has to do with other interest rates to begin with.

The effect of the federal funds rate on interest rates

The Federal Reserve raises and lowers its target interest rate to control the growth and size of the economy. This interest rate is also known as the federal funds rate. The federal funds rate is the rate at which banks lend and borrow excess reserves to each other, usually on an overnight basis. The law requires banks to keep a certain percentage of their customer’s money on reserve. As a result, banks lend money back and forth to meet these reserve requirements. (Although on March 15, 2020, the Board of Governors of the Federal Reserve System reduced reserve requirements to 0% as a result of the ongoing financial crisis.)

When the federal funds rate changes, it influences other rates — some more so than others. The prime rate, for instance, closely tracks the federal funds rate. The prime rate is the rate banks charge customers with excellent credit scores, and it’s often used as a benchmark rate for short-term and variable-rate loans such as credit cards, car loans, and mortgages with adjustable rates.

Although the Federal Reserve doesn’t set the prime rate, banks tend to set their prime rate based partly on the federal funds rate set by the Federal Reserve. The federal funds rate also influences longer-term interest rates, such as the 30-year fixed-rate mortgage, but to a lesser degree. The 30-year fixed-rate mortgage is also influenced by the economy and inflation, and it tends to loosely track the yield on the 10-year U.S. Treasury bond, not the prime rate.

When the federal funds rate is lowered, the idea is that the lower rate eventually makes its way to consumers and businesses. Because borrowing money becomes less expensive and saving money becomes less lucrative, lower interest rates encourage consumers to spend rather than save and that injects more money into the economy. This spurs inflation and helps the economy grow.

Interest rates have remained low for more than a decade since the collapse of the Lehman Brothers in 2008 and the subsequent global financial crisis. Although the most recent move by the Federal Reserve came with a federal funds rate cut to near zero percent, the Federal Reserve has yet to adopt a negative interest rate policy.

But what if it does? What does that mean for homeowners or those investing in real estate?

Negative interest rates and mortgages

Denmark’s third-largest bank, Jyske Bank, launched the world’s first negative interest rate mortgage in August 2019. The charge on these mortgages was set to be -0.5% a year. This essentially means the bank pays customers to borrow money. Consequently, borrowers end up paying back less than they have been loaned. How would that work? Here’s an example:

You apply for a mortgage with a bank offering negative interest rates. You’re approved, and you receive a 30-year, $200,000 mortgage with a -0.5% interest rate. At a -0.5% rate, your monthly payment is $514.81, or $6,177.72 for the year. However, the amount you owe after the first year is $192,838.65, which is a reduction of $7,161.35. The difference between what you paid and the reduction in the balance of your mortgage is $983.63, or just a little less than 0.5%. This reflects the 0.5% payment you, the borrower, receive due to the negative interest on a slightly declining balance.

Now, let’s compare the same negative mortgage rate with a 0% mortgage rate and the current average 30-year fixed-rate mortgage of 3.31%, according to Freddie Mac (as of Apr. 20, 2020). We’ll account for the full 30 years of the mortgage.

Mortgage rate	3.33%	0%	-0.5%
Monthly payment on $200,000 mortgage	$879.22	$555.56	$514.81
Total interest paid	$116,518.54	$0	-$14,666.73

You might be wondering how to get a loan like that. But because banks need to make a profit, borrowers likely wouldn’t be offered negative interest rates. Interest rates on home loans include a markup (or spread) that represents the lender’s profit. This spread is the difference between the interest rate the bank pays for that money versus what it charges you to borrow that money. This is why mortgage rates are higher than Treasury yields, even though mortgage rates track Treasury yields.

So even if the federal funds rate drops to zero or below zero, you may not see 0% or negative interest rates offered on mortgages. But that doesn’t mean you won’t see any savings.

What 0% or negative interest rates mean for refinancing

When the federal funds rate drops, there is a potential for homeowners and real estate investors to save some money. However, it won’t be immediate. That’s what James McGrath, co-founder of the New York City real estate brokerage Yoreevo, says.

“Investors will have to wait a bit before low interest rates start to benefit them,” McGrath says. “Although mortgage rates usually track the 10-year U.S. treasury very closely, they have remained stubbornly high.” This spread is what will keep investors or homeowners from seeing the same low interest rates that banks see.

But although you might not see mortgage rates at or below zero, average interest rates should lower. As always, it will remain important to shop around for the best rates. Those looking to refinance, whether it be a mortgage, home equity line of credit (HELOC), or home equity loan, should compare the potential savings with any costs associated with refinancing to see whether it makes sense.

Although lowered interest rates can benefit homeowners and real estate investors, they’re also leading to a flock of people trying to take advantage of them. This, in turn, might actually result in mortgage rates going up due to the higher demand. That’s what Matt Edstrom, CMO of GoodLife Home Loans, had to say when discussing the impact of the current 0% federal funds rate on those looking to refinance.

“Currently, so many people are looking to refinance their mortgage that it might be more beneficial to wait a few weeks and refinance once things mellow out. In the past few weeks, mortgage rates have actually gone up to 3.88% because the demand to refinance is so high. The reason being is that the low rates have driven people to want to refinance, including cash-out refinance, which is becoming staggering for banks to keep up with. One reason that the best mortgage lenders will up their rates is to make them more profitable …. Another reason is to try to discourage new business because they are so backed up currently. If you are looking to refinance, wait a week or two and look at your options before making any quick decision.”

Bottom line

As the Federal Reserve continues to implement measures to keep the economy afloat, it may create some big opportunities for homeowners and real estate investors to save through refinancing. Some think now could be a good time to buy real estate and also to refinance, while others disagree. The Federal funds rate is currently very low, as is the 30-year fixed-rate mortgage average and 10-year Treasury yield. This could mean there is still further room for rates to come down.

In any case, whether you’re refinancing your primary residence or an investment property, be smart and keep your eyes peeled for opportunities to save money.