Legacy of High Interest Rates Damages the Economy

interest rate

The media is full of stories about borrowers in trouble with the banks charging high interest rates, but what exactly is an interest rate and how do the banks calculate it? Read on to be an informed consumer and know your rights when it comes to bank interest rates on your loans.

The European Central Bank (ECB) sets a key rate as a guideline to retail or commercial banks. This key rate is based on economic factors; mainly the rate of inflation and the rate of economic growth (Gross Domestic Product or GDP). When GDP is negative for two quarters in a row the economy is in recession. This was the case in Cyprus in 2012, for example.

The ECB knows that if an economy is in recession, people have trouble with keeping jobs, buying products and paying their loans, so it reduces the key rate according to the depth of the crisis. In 2012, the crisis was bad, so bad that the ECB’s key rate plummeted to negative figures. The retail banks in Cyprus and other EU countries were able to borrow money at record lows, and were supposed to pass on the benefits to consumers, but instead of reducing their interest rates to compensate for the bad economy, they kept them high. This was disastrous for the economy. Not only could people not pay back their loans, but much-needed capital sat in the bank’s holding accounts doing nothing.

In Cyprus, this gave rise to a complex legal situation in which the banks are entirely in the wrong. The banking system is supposed to respond to central bank cues, raising and lowering interest rates in accordance with the key rate – and in accordance with people’s ability to repay their loans. Contracts signed prior to the financial crisis had to be restructured but few customers were compensated for their losses due to high interest rates when the economic performance was bad. Instead of keeping their running costs lean and reducing their overheads to avoid burdening consumers with high interest rates, the banks had many branches, large buildings, and high salaries for employees.

What this means is that vital financial resources were drained from borrower’s accounts at the time when they most needed it. The distress, worry and concern caused by such predatory lending is unfair. Unfair contracts are illegal in the EU, and there is plenty of legal precedent to make it more attractive for banks to get real and help their customers instead of threatening them with pointless foreclosures that will just sit on the market because nobody has the cash or incentives to buy them.

Imagine how much better the economy would be now if the banking sector had responded responsibly during the recession and lowered their interest rates significantly to prevent defaults. If they had said ‘we’re all in this together’ and found the right ways to help their clients. Instead, they played dumb, sat on their unfair contracts and put the squeeze on borrowers.

But the facts speak for themselves. It is illegal for a bank to disconnect its interest rate calculations from recognised benchmarks like central banks. The bank must be able to show that it links its interest rates with central bank rates in some way. Anything else is unfair. It is predatory.

The bank must also show how your loan installment is distributed into the capital owed and the interest payments. You need to have a clear picture of the total amount that will be due over the term of the loan, including interest payments. If you think a car is going to cost you 5000 Euros, and you borrow money to buy it, you must be clear about the total amount you will pay over time. The banks will often point you in the direction of a headline interest rate percentage, like 7%. It doesn’t sound very much, does it? But if you add up the total and end up paying 15,000 Euros for a 5000 Euro car, then the 7% is just a red herring intended to misdirect you from the true cost of your borrowing. Can you afford to pay another 10,000 Euros for your car? Likely not, and the drain on your cash flow would prevent you from making other purchases or paying for other things you need.

That is why high, non-transparent interest rates are damaging to the economy. Consumers can suffer serious financial damage. That means the economy can’t get straight no matter what. Assets sit there deteriorating. Money that should be circulating in the economy stays locked in the bank’s vaults instead of being useful. On the human side, families can be left destitute, their futures destroyed by selfishness, greed and the lack of management in the banking sector. Where does it make sense that the working population is crippled by predatory lending? How will anyone make a living, including the banks?

A lot is made about the non-performing loans. What about the non-performing banks? They must take responsibility, the minute they do so, things will improve. That’s the way with responsibility, it becomes a community effort.

It’s in your interest to understand interest rates.