Jun 04, 2020

The Downside of a Low Federal Interest Rate

Mention low interest rates and most people react with excitement—“yahoo, loans are cheap!” The interest rate on your credit card decreases. You can refinance your mortgage or other loans to a lower interest rate. Suddenly, you have a little extra money in your pocket. 

Paying less to borrow money is a good thing, right? Sure—but there are also downsides to a low federal interest rate that can impact small business owners. Your customers’ income streams could decrease due to lost compound interest, reductions in pension payments, elusive loans, and stock market turmoil—and your business insurance premiums could increase.

Savers Earn Less

Savers earning less can curtail the spending habits of your current and future customers.

When the federal interest rate decreases, the interest rate offered by banks on saving accounts usually follows suit. This can discourage household savings: why put money into a savings account earning a low rate of return when you could buy a stock and potentially earn more?

As a result, savers contribute less to their savings accounts. Then the cost of missed compound interest kicks in. Compound interest, according to The Balance, is interest earned on money that was previously earned as interest. Less money in the account earns less interest—and less interest earned becomes less interest compounded. In the end, the pot of gold at the end of the rainbow shrinks as the compounding benefits diminish.

To put it in numbers, use a compound interest formula:

As rates shrink, current customers who depend on interest as part of their income streams might tighten their spending belts and buy less.

According to the Oxford Economics report “Another Penny Saved,” the amount people save now can also have an impact on the economy for the long term. Less saving now means your future customers might have less money to spend, possibly leading to a future economic slowdown.

Social Security and Pension Funds Could Decrease

Smaller Social Security or pension payments can impact retirees’ income. While it’d be great if Social Security and all pension funds were fully funded, that is not always the case.

Social Security is funded partially by the returns on its investments. Per law, Social Security uses special-issue Treasury bonds to reinvest its surpluses. The lower the federal interest rate, the more likely those bonds will have lower yields. Lower returns mean less money available to withdraw from the Social Security bucket.

Many government pension funds face a similar issue. To grow, these pension funds depend on their assets growing over time. Ideally, a pension fund would achieve most of its returns from low-risk investments. However, low-risk investments tend to have lower returns in a low-interest environment. This forces the pension manager to invest more of the fund into higher-risk (and potentially higher-return) investments to achieve the overall target rate of return. Decreased earnings on the low-risk portion of the investments plus losses from the high-risk portion may mean the pension becomes underfunded for future withdrawals.

Underfunded Social Security or pension plans may result in reduced payments to participants, thereby reducing your customers’ discretionary income.

Borrowing Money Could Become Harder

Loans may become harder to secure in a low-interest-rate environment.

Low interest rates mean banks have less money in their deposit accounts as people save less. And it means smaller profit margins to the banks—so they place higher standards on their loans.

If higher interest rates in 2019 led to more loan approvals, then it’s logical to predict that lower interest rates could lead to fewer loan approvals. As a small business owner, finding a bank willing to loan you money could become tougher, especially when interest rates fall during a recession.

And if your customers use loans to buy your products (like an auto loan or a home equity line of credit), they may face increased challenges when borrowing money.

Stock Market Risks

If your customers decide to invest in the stock market rather than depositing their money in a savings account, you might expect them to have more discretionary income, based on the stock market’s potential for greater returns. But depending on the type of investments and mix of stocks in customers’ portfolios, this might not be true.

Historically, not all segments of the stock market have responded positively to a lower federal interest rate. For example, financial stock values often decline when banks earn less interest on loans.

Additionally, market bubbles can occur. When that bubble bursts, corresponding stocks lose value—which could impact your customers’ income.

Insurance Premiums May Increase

From an expense perspective, a small business may encounter an increase in insurance costs. Insurance companies invest insurance premiums and expect to earn enough to cover the cost of paying out on policies. However, if their investment earnings don’t cover the cost of their liabilities, then the insurance company is likely to raise their premiums to cover their costs.

A low federal interest rate, while reducing the cost of borrowing and spurring consumers to spend money, may actually impact your small business revenue and expenses in some surprising ways. With that knowledge, take steps now to increase customer loyalty and improve your sales strategy.

About the author

Katherine O'Malley
Katherine O'Malley
Katherine O'Malley is a contributor to the Lendio blog. A technology geek at heart, she splits her time between traveling, freelance writing, database administration work, and implementing SEO on her travel blog. In her free time, she loves to research the challenges small-to-midsize tourist suppliers face and find ways that technology can help them out.

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