What Happens When Interest Rates Rise?

When interest rates rise or fall, this influences many things in the economy. In this article, we’ll look at the things that happen when interest rates go up. What happens when interest rates rise?

When interest rates go up, the cost of borrowing becomes more expensive. This means that demand for lower-yield bonds will go down, causing their price to drop.

The rise of interest rates impacts both consumers and businesses by forcing them to cut back on spending. When this happens, stock prices will drop, including their earnings. Also, borrowing becomes expensive and will lower the value of bonds because they give out fixed interest.

The relationship of interest rates, the economy, inflation, and the effects on consumers and business is complicated. You have to understand what experts consider as interest rates and their impact on the financial market.

Read on and learn more about what happens when interest rates rise including what happens to stock and bond prices.

What Happens When Interest Rates Rise?

When interest rates go up, the cost of borrowing becomes more expensive. This means that demand for lower-yield bonds will go down, causing their price to drop.

Annually, lenders usually charge a certain amount to borrowers on top of the principal to use their assets, such as cash, vehicles, buildings, or consumer goods. This interest rate is known as the annual percentage rate (APR).

What Happens to Consumers When Interest Rates Rise?

When interest rates go up, consumers tend to cut back on spending. On the other hand, when interest rates go down, consumers will increase spending, resulting in an increase or decrease in stock prices. The consumers’ spending patterns and the stock market have an inverse relationship with interest rates.

To explain it simply, when you are a consumer, you don’t usually apply for a loan when the interest rates are high unless you have to. This will decrease your spending. But when interest rates are high, you would invest in stocks or bonds, which would increase your expenditure. Nonetheless, you will not risk your money in applying for a high-interest loan.

What Happens to Businesses When Interest Rates Rise?

The effect of interest rates on consumers is the same. Consumers will cut back on spending when interest rates rise and increase their spending when interest rates fall. Lower interest rates offer cheaper borrowing costs, motivating people to borrow.

Also, there will be lower interest on mortgage payments, which homeowners would surely appreciate. However, the smaller returns on savings and depreciation of the exchange rate are disadvantages for people who depend on their savings and foreign investments as income sources.

Meanwhile, stock prices would generally fall when interest rates rise, and they would rise when interest rates fall. What happens to consumer and business spending when the interest rates go up? They would certainly spend less.

Advantages of Increased Interest Rates

1. Increased Earnings for Depositors

Depositors and investors would earn more interest through their investments. Typically, banks offer more than two percent interest on deposits. This rate is considered significant if you have deposited a considerable amount of money.

2. Increased Earnings for Investors

People who invest in certificates of deposits (CDs) in banks and bonds will increase their earnings. Banks offer higher interest rates for CDs than regular accounts. But the CDs have a fixed time wherein you cannot withdraw your savings before the maturity date. If you do, you will lose money instead.

Putting your money in bonds could also increase your earnings through increased interest rates. However, if you have old bonds, they would not earn as much, as their value is decreased as compared to the new bonds.

3. Homeowners May or May Not Benefit from Increased Interest Rates

Homeowners owning old houses with fixed mortgage interest will benefit from the interest rates rise because their mortgages will not get affected. Those with adjustable-rate mortgages would get affected by the increase. Consequently, homeowners, who will be buying their homes for the first time, will suffer the consequences of higher interest rates.

4. Stock Investors May or May Not Benefit from Increased Interest Rates

Rising interest rates can increase the prices of some commodities, and as a stock investor, this can be a disadvantage because your expenditures would increase. However, your stocks’ costs will increase, and if you trade them wisely, you could earn money.

Disadvantages of Increased Interest Rates

what will happen if interest rates go up

1. Businesses and Consumers Will Spend Less

Businesses and consumers will tighten their belts because as interest rates increase, many consumer goods would rise in prices. Inflation may occur as the economy tries to find stable ground. 

2. Inflation

The rate of inflation decreases when interest rates increase. Banks usually increase their interest rates when the economy is strong and lower the interest rates when the economy is weak. Additionally, the economy grows when there are low-interest rates. But when interest rates are high, the economy slows down.

Inflation indicates a decrease in the purchasing power of a country’s currency and an increase in most products’ prices. Low-interest rates would increase inflation, and high-interest rates would decrease inflation. Thus, interest rates and inflation are inversely proportional to each other, while inflation and economy are, in some ways, directly related to each other.

Yet, too high inflation can be bad for a country’s economy. But when the government controls inflation so that it becomes reasonable, the country’s economy can prosper.

3. The Value of Fixed-income Investments, Such as Individual Stocks and Bonds Fall

This effect is due to the fixed interest these investments earn, despite the interest rate increase on new bonds. This rate will not increase your bond’s interest rate because it’s a fixed interest investment.

When interest rates rise, your bonds’ value falls. Therefore, you must be smart when investing in bonds. Choose shorter maturity terms, and don’t put all your money on bonds and stocks.

4. Increased Monthly Payments for Debts 

Examples of these debts are credit cards, debit cards, student loans, and homeowners with adjustable-rate mortgages. You would notice an increase in your monthly payments when the interest rates rise.

Any financial vehicle that has an adjustable interest rate would suffer this consequence of increased monthly amortizations.

We’ve answered the questions: “What happens when interest rates rise?” and “What happens to consumer and business spending when the interest rates go up”; next, let’s now proceed to tips for coping with the rise and fall of interest rates.

Tips for Dealing with a Rise in Interest Rates 

1. Learn How to Invest Wisely When Interest Rates Rise

You can increase your savings in the bank or convert some of your savings to CDs.

Invest in businesses that offer the same increased interest rates and ensure that they have a good track record. You wouldn’t want to see your money down the drain when the company goes bankrupt, after offering high-interest rates on your investment.

Find trusted companies with an excellent track record and invest some money. Additionally, it is smart not to put all your eggs in one basket, so learn how to diversify.

2. When Interest Rates Fall, Learn How to Invest Correctly

This time is the right moment to apply for a housing loan. Make sure you apply for mortgages with a fixed interest rate. When interest rates increase, it will not affect your monthly payments later on.

You could also buy real estate properties and sell or rent them out at a higher price when interest rates increase in the future. Investing in housing units is riskier than investing in lands.

This time is ideal for borrowing money on a fixed interest rate so that you can take advantage of the low interest on your loans. Take note not to borrow money from financial products that have adjustable interest rates. Over time, this could bring you harm, and you may lose money when interest rates increase. When in doubt, ask questions before borrowing.

3. Learn the Value of Bonds and How to Make the Most Money

Secure your bonds from legitimate corporate companies that have a form of guarantee or insurance for your bonds. As mentioned previously, to play safe, opt for treasury bonds instead. The U.S. government would certainly pay you the capital and the interest of your money upon maturity.

For government bonds, a more extended period of maturity is safer, but it’s better to choose a shorter time for corporate bonds. If you’re about to retire, treasury bonds are less risky and more stable for you.

Although big company stocks may offer more significant gains than bonds, bonds are less risky. But if you are confident about the viability of your stocks, then go for it.

What Are Interest Rates?

An interest rate is the proportion of a loan that is charged to the borrower, typically expressed as an annual percentage of the outstanding loan. There are two different types of interest rates: simple interest rates and compound interest rates.

1. Simple Interest Rates

This interest only involves the amount charged for the principal loan. Generally, consumer loans use APR.

2. Compounded Interest Rates

This interest involves the amount charged for the principal loan plus the accumulated interest of the previous periods. Bank deposits or savings accounts use annual percentage yield (APY), which provides compounded interest rates.

Low-risk loans have lower interest rates, while high-risk loans have higher interest rates.

What Are Bonds? 

Bonds represent loans made by investors to corporate or governmental borrowers that give fixed incomes to investments. The borrowers pay fixed interest to the creditors commensurate to the creditors’ invested money. The bond’s owners are the debtors or creditors who finance projects by corporate companies, states, or sovereign governments. 

what happens when interest rates are increased

Types of Bonds

1. Corporate Bonds

Corporations can issue bonds to finance their projects or increase their capital investments. The risk is greater with corporate bonds than government bonds because you would not be sure if your money will be safe when the company goes bankrupt. However, they often offer higher investment returns and perks. So, you will have to choose cautiously the company you want to invest in.

2. Treasury Bonds 

The U.S. government issues these bonds through the U.S. Department of Treasury. Typically, the maturity dates range from 30 days to 30 years. The advantage of treasury bonds is that they are liquid, have decreased risk of default because you can trade them quickly in the secondary market, and payments of interest and principal are timely. In addition, these bonds are exempt from federal income taxes.

3. Municipal Bonds

These are bonds issued by local or state governments to finance their public projects, such as roads, housing, schools, and similar projects.

These bonds provide competitive rates but are riskier. Unlike the U.S. government, local governments can go bankrupt. And when this happens, you may or may not lose your investment, depending on the type you have secured. In some states, investors are exempt from paying income taxes or local taxes, but not all are exempted.

How Are Bonds Affected by Interest Rates?

What happens to bonds when interest rates go up? When interest rates go up, the prices of bonds become lower. Bond prices are affected by the increase or decrease in interest rates. When interest rates go up, bond prices go down. Consequently, when interest rates go down, bond prices go up. They are inversely proportional to each other.

Nonetheless, bonds are safer investments than stocks, as stocks are quickly affected by inflation and interest rates. Bonds have a more stable status, especially if they are treasury bonds issued by the U.S. Treasury Department. You would surely get your capital back together with interest.

Conclusion – What Happens When Interest Rates Rise?

So, to recap, what happens when interest rates rise? The rise of interest rates impacts both consumers and businesses by forcing them to cut back on spending. When this happens, stock prices will drop, including their earnings. Also, borrowing becomes expensive and will lower the value of bonds because they give out fixed interest.

Borrowing becomes expensive, discouraging people from doing it. Hence, consumers and businesses take a cut back on spending.

The rise of interest rates impacts both consumers and businesses by forcing them to cut back on spending. When this effect happens, stock prices will drop. Borrowing becomes expensive too. The prices of bonds decrease and lose value, as well.

There are pros and cons of interest rates increase. Ensure you know what type and plan you want to invest in to increase your investment’s gain and avoid losing money.