Interest rates are a key part of financial decision-making, from securing loans and managing debt to building savings and investing. Understanding the dynamics of interest rates helps individuals manage their finances more effectively.
When interest rates rise, it can affect borrowers, lenders, savers and investors in different ways. For example, a borrower might see their loan principal increase after a year, so they end up owing more to the lender than they initially did. When interest is compounded, the additional amount owed increases even faster.
Some borrowers can benefit from higher rates, especially if they have variable-rate debt, such as a mortgage or credit card balance. This is because a higher rate means they’re paying more in interest each month, which can help reduce spending or prevent spending from going too high. But higher rates also mean less money for other, optional or discretionary, purchases like a night out at a restaurant or movie tickets.
A rise in rates can also lead to higher costs for businesses with variable-rate debt, such as commercial real estate loans. This can have a ripple effect, reducing demand for goods and services.
Investors can often gain from higher interest rates by buying bonds, which earn a higher yield when the rates go up. In addition, companies with profit margins that expand as rates go up, such as banks, insurance companies and brokerage firms, usually benefit from higher rates. However, a rise in rates can also have a negative impact on the economy by slowing growth and potentially causing inflation.