Sunday, May 3, 2009

Saving When Interest Rates Fall

When interest rates go up, it gives people a greater incentive to save. Higher interest rates on loans make it more important to pay off a loan quickly, and higher interest rates on savings accounts give you an extra reason to put money in the bank. Yet this year, people are saving more because interest rates have gone down.

It’s not that mysterious, really. People who can reduce their mortgage rates can spend less every month on mortgage interest. They can pocket the extra money, use it to pay down their mortgage principal, or better yet, pay off any credit card balances.

This is a bigger trend in the United Kingdom than in the United States. U.K. mortgage rates have fallen significantly, and borrowers paid off a record £8 billion in mortgage principal in the fourth quarter of last year, according to a story in today’s Sunday Herald.

U.S. mortgage interest rates have fallen mainly for homeowners who have more than 25 percent home equity. Some people are using their newly reduced mortgage payments to pay off their car loans faster. Others are just making extra payments on the mortgage.

It’s a windfall for consumers who might end up paying off their mortgages three years sooner just because of the decline in rates. Yet it’s a frustration for central bankers. The Fed lowered interest rates to zero to try to get people to save less and borrow more so they can spend more, but in the short run, it is having the opposite effect. That is one reason extra government spending in this situation is helpful to the economy. The extra federal government spending this year seems huge, but it is not likely to be enough to counter the effect of the reduced spending by consumers, never mind the cutbacks in business and state government.