The Downsides of Record-Low Lending Rates

I don't know about you, but I absolutely loathe paying interest on anything. Whether it's my mortgage, an auto loan, or a credit card, I simply can't stand the concept of someone charging me extra for something I bought, but didn't have the money in my hand to buy. In situations like this, I have to say that I'm pretty darn glad to see lending rates near their historic lows. Within just the past year, I've refinanced my home at rates I never anticipated I'd see, and my variable-rate credit cards are charging interest rates lower than I can ever recall.

This is just my story, and I'm sure there are others out there with similar stories of how low lending rates are positively affecting their lives. But, for each positive story, there are more than a handful of negative effects to having the Federal Funds rate set at 0% to 0.25% for an extended period of time.

Although most economists consider low interest rates to be, on the whole, beneficial to economic growth today, I'll walk you through what I feel are some major drawbacks of an extended period of low lending rates.

1. It discourages saving and harms the already beleaguered baby boomers.
I don't know about you, but I just get shivers of excitement up and down my spine when I see that my checking account with JPMorgan Chase (NYS: JPM) is earning 0.01%. That's right ... no misplaced commas or fat-fingered mathematics here. I'm really earning just one-hundredth of one percent on the money in my checking account, and that was indeed a big sarcasm sandwich I just laid on you. At this rate, my money will double by the year 9,200!

Although there are better alternatives out there than JPMorgan's anemic 0.01% checking account yield, like ING or Ally Financial, which offer rates of 0.25% and 0.75%, respectively, with little to no deposit required, these rates are nowhere near high enough to outpace the average rate of inflation. Even with inflation levels currently at 1.4% in July, significantly below the 3.6% average since 1914, you're doing yourself a disservice by letting your money lose value in your bank account.

Perhaps no group is harmed more by low interest rates than the baby boomers, who took the biggest brunt of the housing and stock market downturn. This group, who really can't afford to be taking huge risks based on their age, is having a nearly impossible time trying to find a decent rate of return from CDs and bonds that will also outpace the inflation rate.

2. It's creating a pension landmine.
With the stock market and the housing bubble negatively impacting many American's lives over the past five years, workers from all over the U.S. and across a wide swath of industries are counting on their pensions to supply them with ample income to live off of during retirement. For certain companies, as my Foolish colleague Dan Caplinger recently pointed out, this could become a serious problem.

As Dan notes, both wood and paper-focused real estate investment trusts, Weyerhaeuser (NYS: WY) and Potlatch (NYS: PCH) , run their pension plans for future retirees with the assumption of aggressive returns. Potlatch assumes an average annual growth of 8.5%, while Weyerhaeuser expects annual growth of 9%. Because of these aggressive assumptions, both Weyerhaeuser and Potlatch are allowed to make smaller annual contributions to their pension plans.

If CD and bond rates were anywhere near their historical averages, this wouldn't even be an afterthought; but, with many safer investments yielding well below their historical averages, the potential for these pensions to come up short of their targeted return is very feasible. If these and other companies begin to miss their growth targets, they'll need to make up the cash shortfall.

3. ...and an insurance nightmare
In addition to being a pension nightmare, low lending rates are beginning to cause serious profitability problems in the insurance sector.

The insurance sector relies on two factors in order to make money. First, if a member pays his or her premium, and the policy goes unused (i.e. there is no claim), the insurance company pockets the entire sum as a profit. In addition to pocketing premium, insurance companies also commonly leverage their investment portfolio to include heavy doses of fixed-rate and government-backed debt instruments. Warren Buffett's Berkshire Hathaway (NYS: BRK.B) is one notable exception that actually owned about 2.5 times as much in stocks as it did in fixed-rate maturities at the end of last year.

The same can't be said for Travelers (NYS: TRV) , which had $64.2 billion of its $72.7 billion invested in these low-interest bearing, fixed-rate securities, at the end of its fiscal 2011. A low interest rate environment, especially an extended one, threatens to further reduce consumer interest in annuity offerings, and could cause insurance companies to reduce the number of products they are willing to offer, and will almost assuredly reduce investment income.

4. It discourages banks from lending.
Yes, you read that correctly -- low interest rates are curbing bank lending. While that might sound counterintuitive at first, give me a moment to explain.

In late March, Federal Reserve Chairman Ben Bernanke noted in a speech that not only have consumers without high credit scores found it difficult to get a loan, but "small businesses have also found it difficult to get credit." Bernanke went on to surmise that, because small businesses are important for job creation, their lack of access to credit is one factor disallowing the start-up or expansion of those businesses, and thus impedes job growth. In fact, between June 2007 and June 2011, loans under $1 million fell 13%, and inflation-adjusted dollar amounts lent overall fell 19%.

What's behind this cutback in lending? Simply put, an extraordinarily long period of low lending rates is allowing banks to borrow at nearly 0%, and then reinvest those funds in longer-term government-backed debt instruments yielding considerably more, say 3% to 4%. Although the banks could find higher returns by investing in small businesses, they're choosing the path of less risk and guaranteed returns. Low lending rates also discourage competition between banks for business loans.

5. But raising rates could thrust the U.S. into a recession.
Perhaps the biggest question is: What's going to happen in 2014 or beyond when the Federal Reserve finally does raise the target Federal Funds rate, and interest rates begin to adjust upward? There's a good chance we'll be thrust into a recession if we're on the mend, and an even worse recession if rates begin to rise before our economy is on stable footing.

Take, for example, the fact that 30-year mortgage rates are still near historic lows, even after a small rebound, and yet refinancing activity dropped almost instantly on even the slightest move higher in lending rates. According to the Refinance Index put out by Mortgage Brokers Association, in late 2010/early 2011, when 30-year mortgage rates rose roughly 100 basis point from 4.3% to 5.3%, the Refinance Index dropped more than 20%. Even worse, in 2009, when 30-year rates had nearly the same 100 basis-point rise to as high as 5.6%, the Refinance Index fell by a third! What happens when rates climb 150 or 200 basis points?

Along those same lines, how can you expect the housing industry to rebound when homeowners have little incentive to purchase now? The Fed's stance on keeping lending rates at historic lows through 2014 allows prospective homebuyers the time to simply wait and see what happens with home prices and mortgage rates, without a real sense of urgency or fear that rates will rise excessively.

What a mess...
Although I'm a personal fan of low lending rates, there's a time and a place for them -- and that time and place has come and gone for the U.S. economy. Without question, low interest rates are boons for larger companies looking to expand, homeowners seeking to refinance, and borrowers who are able to access credit; but it could also stymie lending, lead to homebuyer complacency, and reduce returns for debt investors, like pensions and other bondholders.

What's your opinion on keeping the interest rate target near 0% through 2014? Is this a helpful or hurtful policy? Share your thoughts with your fellow Fools in the comments section below.

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Fool contributorSean Williamshas no material interest in any companies mentioned in this article. He recently eclipsed the $1 mark in bank interest this year. You can follow him on CAPS under the screen nameTMFUltraLong, track every pick he makes under the screen nameTrackUltraLong, and check him out on Twitter, where he goes by the handle@TMFUltraLong.Motley Fool newsletter serviceshave recommended buying shares of Berkshire Hathaway. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has adisclosure policythat's always of interest without charging interest.

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