👨‍🎓 What happens when interest rates rise?

15/52 Macro Mornings Education

Dec 09, 2024

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👨‍🎓 This is part of a 52-week series on macroeconomics designed to build your knowledge step by step. Feel free to catch up on previous emails here if you'd like to start from the beginning!

Dear all,

We’ve discussed the relationship between interest rates and inflation, and now it’s time to explore what happens when interest rates rise and how it impacts your finances.

Rising interest rates can have far-reaching effects on the economy and your personal financial situation. Here’s what you need to know:

1.     Borrowing Costs Increase: One of the most immediate impacts of rising interest rates is that borrowing becomes more expensive. Whether you’re taking out a mortgage, a car loan, or using a credit card, higher interest rates mean you’ll pay more in interest over the life of the loan.
For example, let’s say you’re considering a $300,000 mortgage. At a 3% interest rate, your monthly payment would be around $1,265. If the rate increases to 5%, that payment jumps to about $1,610. Over a 30-year loan, that’s an additional $124,000 in interest!
2.     Impact on Housing Market: As borrowing costs rise, fewer people can afford to take out mortgages, which can lead to a slowdown in the housing market. Home prices might stagnate or even decline as demand decreases. If you’re looking to buy or sell a home, rising interest rates are an important factor to consider.
3.     Savings and Investments: On the plus side, rising interest rates can mean better returns on savings accounts, CDs, and bonds. If you’re a saver, this is good news, as you’ll earn more interest on your deposits. For example, if you have a $10,000 savings account earning 2% interest, you’d earn $200 in interest over a year. If the rate increases to 4%, you’d earn $400.
However, rising rates can also lead to lower stock market returns. As interest rates rise, bonds become more attractive compared to stocks, which can lead to a decline in stock prices. Companies also face higher borrowing costs, which can reduce profitability and, in turn, affect stock valuations.
4.     Consumer Spending: Higher interest rates can also reduce consumer spending, as loans and credit card debt become more expensive. This can lead to slower economic growth as consumers cut back on spending.
5.     Currency Strength: Rising interest rates often lead to a stronger currency, as higher rates attract foreign investors looking for better returns. A stronger currency can make imports cheaper, but it can also make exports more expensive, potentially hurting businesses that rely on international sales.

How can you prepare for rising interest rates? Here are a few strategies:

Lock in Fixed-Rate Loans: If you’re considering taking out a loan, locking in a fixed interest rate now can protect you from future rate increases.
Consider Shorter-Term Bonds: Longer-term bonds are more sensitive to interest rate increases. If you’re concerned about rising rates, consider shorter-term bonds, which are less affected by rate changes.
Review Your Investments: As interest rates rise, you might want to adjust your portfolio, reducing exposure to interest-rate-sensitive sectors like real estate and utilities, and increasing exposure to sectors that benefit from higher rates, such as financials.

In our next email, we’ll explore the flip side - how low interest rates impact the economy and your finances.

Alessandro
Founder of Macro Mornings

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