The effects of cutting interest rates

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As we have seen during the economic meltdown caused by Coronavirus, most central banks around the world cut interest rates to stimulate the economy. One may wonder – what are the effects of cutting interest rates?

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• The aftermath of the Coronavirus pandemic – what to expect.
• Raising money for investments.

What is the impact of interest rates? How effective are they in affecting the behavior of people? In this article, we discuss the effects of cutting interest rates on investors, those who save, businesses and borrowers.

As you may have heard, the Central Bank can cut the Repo and Prime rates. Repo rate is the rate that the commercial banks (like Absa, African Bank or Nedbank) pay in order to borrow money from the Central Bank (South African Reserve bank). The Prime rate is the lowest rate that is used by a commercial bank to determine the interest rate to charge its clients on loans. Interest for mortgages, credit cards and other types of loans are calculated based on the prime rates.

The effects of cutting interest rates on borrowers

When the repo rate is reduced, the prime rates are also likely to be reduced. Therefore, commercial banks and other lenders will reduce the interest rates on mortgages, credit cards or other loans. The effect is that you will be paying less to borrow.

This is only possible if you are being charged floating (variable) interest rates. Borrowers who are paying fixed interest rates will still continue to pay high interest rates on their loans. Therefore, if you have a personal loan with a fixed interest rate of 20%, you will continue to pay the same interest despite the fact that the repo rate is reduced.

For borrowers who are being charged floating interest rates, it becomes cheaper to borrow money. Many people will desire to borrow money at a lower interest rate and the commercial banks will borrow more money from the Central Bank at a cheaper repo rate. This increases the money supply in circulation. This will likely increase the demand of goods and services.

Another way of understanding the impact of interest rates on demand is by considering how your budget as a borrower is affected. Suppose that you have been paying interest of R 1 000 every month on your loan. If interest rate is reduced, and your new interest amount is reduced to R 800 then you have R 200 to spend on other things. Therefore your propensity to spend increases.

Effects on investors and those who save money

As an investor, you need to understand how interest rates work. Interest rates can either be your greatest friend or enemy.

Saving products

For those who are saving money, low interest rates may mean low interest on your savings. Suppose that you have a Notice deposit account with Nedbank, if the central bank reduces the repo and prime rates, Nedbank may also reduce the interest on your Notice Deposit account. Therefore, your income on your savings is greatly reduced.

However, other commercial banks may choose not to reduce the interest rate on their savings products as a way of keeping their clients. But generally few banks will do that. It also depends on the saving products being offered – some have fixed interest rates which are not affected by the changes in repo rates.

In general, reducing interest rates discourages saving money and promote spending.

Bonds

How does the interest rate affect an investor who invest in retail or government bonds? The key note is that interest rates and bond prices are inversely related. That is, the lower the interest rates in the market, the higher the bond prices.

Suppose you invest in a South African Government Bond with a 12% coupon rate but due to Coronavirus, the South African Reserve Bank reduces the interest rates to 10%. Since you still hold a bond that pays 12%, your investment is more valuable. If you are to sell your bond to the market, it will have to be expensive because whoever is going to buy the bond will earn a coupon rate of 12% instead of the 10% being offered in the market.

Stocks, Property and other Investments

Interest rates can help to stabilise the stock market after a crash. The easiest way to look at this is to understand the source of the money investors use to invest.

Most investors borrow money to invest (this is often called good debt). If the interest rate is reduced, an investor can borrow money from the bank at a cheaper price and invest in shares, property or any other form of investments. The investor’s returns will increase because the interest payments on debt will be low.

Additionally, if the money supply increases, this enhances your ability to invest because you have excess money on your budget.

Low interest rates may give a short term relief to those companies that are struggling to pay interest on their existing debts. This will greatly reduce the chances of filing for bankruptcy during a crisis. This is likely to push the share price up in the short run. However, if the company increases its debt, this will likely to affect its ability to pay dividends in the future.

The effects of reducing interest rates on businesses

There are generally two ways on which reducing interest rates can be good on your business.

Firstly, if you are a business owner relying on debt, if interest rates are reduced, then your costs of production will reduce. Therefore, low costs of production can help your business to produce more. This can make it easier for you to realize profits.

Secondly, the large money supply in circulation and growth in demand can allow your customers to afford to buy whatever you are selling. The more you sell, the higher are your chances of making profits.

Conclusion

The effects of cutting interest rates can be great depending on whether you are investing, saving or borrowing. Reducing interest rates will make borrowing cheaper and this will increase the money supply in circulation. Central banks can cut interest rates to help the stock market or property market to bounce back after a crash.