Oran Hall | The good and bad of low interest rates

Low interest rates can be quite a mixed bag.

They make it cheaper for people to borrow to acquire assets and to boost consumption, but they may also cause lower investment returns or higher investment returns. They can make individuals better off or worse off, depending on how they are used, and can also affect the economy positively or negatively.

When interest rates are low, consumers find borrowing more affordable and often tend to borrow more. How beneficial this is depends on what the borrowed money is used to do. Borrowing to spend for short-term satisfaction is perhaps the least beneficial purpose though some will argue, with justification, that a loan can be useful in plugging a short-term hole in the budget due to emergencies or unforeseen demands for cash.

Ideally, though, such a situation can be avoided by having an emergency fund.

Borrowing to acquire long-term personal assets, such as a motor vehicle or furniture, can be worthwhile. Let’s face it. It is likely that some people would not be able to acquire certain worthwhile assets without using borrowed funds, but good sense should prevail - the loans should not be burdensome to service.

One particular asset that becomes more attractive to buy when interest rates are low is property. Low mortgage rates make it easier for prospective home owners to afford to borrow and thus realise a long-term goal that ranks high on the scale of priorities of many people.

Another long-term asset that low interest rates can help to foster is education, which has the ability to change the lives of individuals and their family members for generations because of the human capital that education helps to engender.

Then there is the debatable issue of whether people should borrow to invest. This is not for everybody as it is fraught with risk. It has the potential to boost net worth but can be devastating if the investment programme flounders.

Low interest rates mean low returns on savings instruments, generally below the inflation rate, thus yielding a negative real return. Even when interest rates are high, this tends to be the case as the inflation rate tends to be relatively high in such cases. People who are wedded to savings instruments, nonetheless, should aim to get the best safe rates by favouring fixed deposits over savings accounts while bearing in mind the safety of their funds. Thus, it is important to favour financially stronger institutions.

The returns on unit trusts and mutual funds which invest primarily in the money market and in bonds are also impacted negatively given the lower returns on interest-bearing securities. Bond funds, though, have an advantage as lower interest rates cause the value of bonds bought previously to increase and can be quite beneficial to the fund.

Low interest rates are not good for interest-sensitive life insurance policies as the value of such policies fluctuates with interest rate movements although they do lend stability to the value of such policies.

Low interest rates can be bad news for people on fixed incomes, like most pensioners, who must earn as much as possible from other sources of income to be able to maintain their standard of living in the face of rising prices.

For those who invest in bonds when rates are high and for the long term, low rates can make good music, particularly those who depend on interest income to provide living expenses. The reason is that the interest income in such cases exceeds that on current instruments. Additionally, given the inverse relationship between bond prices and interest-rate movements, lower interest rates mean higher bond prices. Where the need to sell such bonds before maturity arises, the higher prices can yield a bonanza.

When interest rates are low, businesses are able to reduce their expenses, thereby enhancing their chances of increasing their profit, leading, generally, to the price of their stock increasing on the stock market to the benefit of shareholders. Generally, stock markets tend to do well when interest rates are low.

When the economy grows, low interest rates being a contributory factor, as businesses expand, they tend to offer more employment opportunities, thereby enabling more people to earn a living or to improve their earnings.

For the economy overall, increased consumption generally fuels expansion of the economy. Higher consumption creates the risk of stoking inflation. Further, when it leads to increased demand for goods and services from the rest of the world, this may cause pressure on the exchange rate, leading to depreciation in the value of the local currency, higher prices for imports, and the likelihood of a spike in the inflation rate.

If local interest rates are below rates that are available in the rest of the world, it is likely that funds will move into foreign currencies, thereby possibly leading to the value of the local currency losing value with the negative consequences I mentioned above.

Prudent people benefit most from low interest rates as they do not go overboard on spending, especially for consumption, borrow responsibly to make their assets grow, borrow within their means, and save and invest responsibly.

Oran A. Hall, author of Understanding Investments and principal author of The Handbook of Personal Financial Planning, offers personal financial planning advice and counsel.finviser.jm@gmail.com