Interest rates are often in the news these days, due to their effect on so many people’s lives. In August 2024, the Bank of England dropped interest rates for the first time since the UK entered the COVID-19 lockdown in March 2020.
Interest rates affect:
- Mortgages
- Credit card borrowing
- Savings
- Investments
In this article, we’ll examine the close links between inflation, interest rates and investments.
Interest rates definition
If you borrow money, the interest rate is the fee you will be charged for borrowing that money. If you save money, the interest rate is the amount you are rewarded for saving.
The relationship between investments and interest rates
The relationship between investments and interest rates is inverse. That might sound complex, but all it means is that when interest rates rise, bond prices fall. And vice versa. So, when interest rates increase, it’s more expensive to borrow money.
It’s very important for investors to understand this relationship, as even seemingly small changes in interest rates can significantly affect different types of investments.
How does interest rate affect investments?
How interest rates influence borrowing costs
If interest rates rise, your borrowing becomes more expensive. Whether you’re looking for a mortgage, a credit card offer or a new car, it will cost you more money than the previous interest rate.
The impact on consumer spending and business investment decisions
An interest rate increase has far-reaching effects on everyone, as it reduces disposable income and limits consumer spending.
Businesses and investors pay close attention to consumer spending. If consumers are spending less, businesses and investors are less likely to invest because the return on investment can be uncertain. They are more likely to wait until the economy improves.
How interest rates help determine the attractiveness of various investment options
Interest rates can help determine the attractiveness of various investment options.
- Shares – If there is an interest rate increase, and you have shares, the share prices will go down, because businesses incur more costs. However, remember that wouldn’t necessarily affect your dividend in the long term.
- Bonds – Most bonds pay fixed interest rates. So, when interest rates do go down, this drives up the demand and price of your bond. But if there is an interest rate increase, the price of the bond will decrease, because investors will no longer prefer the lower fixed interest rate.
Understanding investment interest rates
Definition and significance of investment interest rates
Investment interest rates are important in business. So much so, people and companies will base investment decisions on the effect interest rates have on them. See the effect of interest rates and shares and bonds, above, for example.
Companies weigh up the marginal costs and benefits of investment decisions. And good investors only undertake an investment if the marginal benefits outweigh the marginal costs.
- Marginal benefit – expected rate of return on investment
- Marginal costs – the interest rate
Different types of investment interest rates
- Fixed interest investments – investors lend money in return for a fixed rate of interest, or ‘yield’. These include bonds or gilts.
- Variable interest investments – as the name suggests, variable interest means the rate can go up or down without your input.
A variable rate offers greater flexibility for investors and the potential for greater returns than fixed. However, there is more unpredictability.
How investment interest rates are determined in the market
The state of the economy plays a significant role in investment interest rates. Most obviously, for example, the Bank of England’s Base Rate decisions, as we’ve already seen, have a huge impact, even potentially with seemingly slight changes.
If the rate of interest is lowered, this stimulates economic activity, because it encourages borrowing and can make investing more attractive than saving.
If the interest rate is increased, borrowing is discouraged, economic activity falls, and makes saving more attractive than investing.
The link between inflation and interest rates
Inflation is the measure of how much the things we buy have risen over a period of time, so there is an inevitable link between inflation and interest rates.
The relationship between inflation and interest rates
Usually, the relationship between inflation and interest rates is inverse. This means that:
- When interest rates are low, inflation normally rises
- When interest rates are high, inflation normally falls
How inflation expectations can influence investment decisions
With the theory above in mind, investors should try to buy investment products with financial returns that are equal to, or greater than inflation.
For example, if stocks returned 4% and inflation was at 5%, then the real return on investment would be minus 1%.
The impact of rising interest rates on inflation and investment strategies
You definitely need to take inflation into account in your investment strategy. As inflation reduces real returns on financial investments and lessens your purchasing power. Which means your investments may be worth less when you really need to use them.
As you can see, if you’re an investor, it’s vitally important to monitor interest rates so you can make informed decisions. Never forget that investments can go up as well as down.
Now you’ve learnt how interest rate can affect investments, if you need help with your investment management & decisions, get in touch today to speak with one of our industry leading, highly qualified investment advisors.
