How are Investors Affected by Interest Rate Changes?

What Goes Up, Must Come Down

Interest rates have a direct influence on your investment prospects, and it is important to understand how these impact your portfolio.

Over the past decade, interest rates have seen their highs and lows. Central banks set interest rates to try and keep inflation under control, while stimulating the modest growth that is the hallmark of healthy economies.

There are plenty of investment options, many of which respond differently to various interest rate scenarios. Stocks, bonds, savings accounts, and real estate are each uniquely affected by interest rate changes.

Where to Invest When Interest Rates are High

Stocks

During periods of high interest rates, the cost of borrowing money increases. This is true for both individuals and companies. This has implications for the stock market as a whole, as companies are less likely to experience high levels of growth when the cost of capital rises. That being said, central banks will usually raise interest rates because they are worried that markets are growing at too strong a clip and are in danger of becoming overheated. That likely means that the stock market as a whole is performing especially well.

Though high interest rates can dampen growth, there is not always a direct or immediate correlation between raising interest rates and tamping down growth; it could take a while for the interest rate increase to take effect. Therefore, removing monies from the market before growth has peaked means forgoing potential profits if stocks continue to rise after you have sold your holdings.

Downturns in the market, not surprisingly, are not great for companies or stocks. However, some sectors are more insulated from recessions or and slowdowns, such as consumer staples, grocery stores, and other items of necessity. If you foresee a slowdown on the horizon, it would be wise to consider diversifying your portfolio to include some of these sectors, or decreasing your exposure to the stock market as a whole.

Bonds

Unlike stocks, the price of fixed-rate bonds is directly–and inversely–related to interest rates. A fixed-rate bond pays the same level of interest throughout its term. When rates rise, bond prices will drop. When interest rates dip, bond prices will increase.

To understand this dynamic, consider the following example: You purchase a bond at a 2% rate, and then interest rates subsequently rise to 3%. Your bond is now worth less because a better alternative, such as placing your money in a saving account, is now available. This is less important for those who will hold their bonds for the full duration, but those wishing to sell their bonds prior to maturity will experience a loss when interest rates rise.

CDs and Savings Accounts

Certificates of Deposit and savings accounts offer safe, strong returns when interest rates are high. The impact on the interest rates offered to savers is not always immediate, however, and there is often a lag between the central bank decision and any subsequent increase in consumer savings accounts.

Where to Invest When Interest Rates are Low

When interest rates are low, borrowing money costs less as you can acquire capital at lower rates. Companies looking to expand may seek to capitalize on opportunities, so emphasizing stocks could make sense in this environment.

Another good choice is real estate. For those looking to purchase a home or other major acquisition, locking in a low-interest rate loan provides an avenue to significant savings over the life of your mortgage. TipRanks’ mortgage calculator can help you understand how different pieces of your potential home loan–down payment, interest rate, and loan tenure–will shape your monthly payments and the overall cost of your mortgage. Experimenting with different interest rates offers a vivid picture into the difference various interest rates will have on your finances, and why it is beneficial to buy when rates are low.

Conclusion: Interest Rates and Your Investment Horizon

Thought savvy investors do not have to play the market on a daily basis in order to generate wealth, understanding the winds of changing interest rates are an essential component to being wise with your money.

Periods of high interest rates can make the stock market a more risky proposition, while simultaneously turning Certificates of Deposit and savings accounts into more attractive options. Low interest rates make it easier to access capital, which can be a net benefit for companies looking to expand and individuals considering major purchases.

Knowledge, as the saying goes, is power. Understanding the market forces at play can help you maximize your returns while taking care of your long-term finances.

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