How interest rates affect investments

Interest rates have long been a bit of a wild card when it comes to investing. They’ve got the power to make even the seasoned investor scratch their head when trying to predict their next move.

Knowing how interest rates can have an impact on your money can help investors feel more in control. As well as being less likely to make quick decisions that could impact them negatively in the long run.

First, though, while this article can give you helpful tips, we can’t give you personal advice. And remember, the value of your investments can fall and rise. You could get back less than you put in.

How do interest rates work?

The Bank of England (BoE) sets the base rate of interest in the UK, and they do this to control borrowing and spending in the economy. When interest rates fall, it makes borrowing cheaper, which allows us to spend more. Which then injects cash into the economy.

But when they rise, it puts the brakes on people and businesses from borrowing, which leads to less spending.

The push and pull of interest rates is what the BoE uses to help keep inflation near its target of 2%.

When inflation is high, it eats away at the spending power of our cash, so we can’t buy as much as we did before with the same amount. The BoE will raise interest rates to try and lower inflation by curbing spending.

But equally, when inflation is too low, people might put off their purchasing, which can actually stall the economy. The BoE will lower interest rates in response to low inflation to encourage spending.

How do interest rates affect investments?

When interest rates fall and rise there’s a direct impact on the stock market and your investments. Here’s how:

1. When interest rates go up, the price of bonds (loans to companies or governments) goes down
   
   This is because most bonds pay a fixed rate of interest (known as the “coupon”). When interest rates are rising, the fixed coupon becomes less attractive so the price of the bond falls. But the extent of the fall depends on a couple of different factors, like when bonds are set to mature and whether they are high or low yielding.
   
   Longer maturity bonds are generally most sensitive to interest rate movements. Higher yielding bonds are less sensitive than lower yielding bonds. Easy huh! No? Well, maybe the best way to invest in bonds is simply to invest in a fund that has a bit of everything.
   
   
2. Higher interest rates reduce the value of growth stocks
   
   Growth stocks are stocks from companies that are expected to grow faster than the overall market. When growth stocks are in decline, it’s usually because higher interest rates make borrowing more expensive for companies. This slows down their growth.
   
   
3. The banking sector typically performs well when interest rates are rising
   
   When interest rates are high, it doesn’t completely stop people from borrowing. But it widens the gap between mortgages, credit cards and other debt, compared to the interest offered on savings accounts, which benefits banks.
   
   
4. Certain industries can benefit from higher interest rates
   
   Companies in sectors like energy and food, that rely on essential consumer spending rather than on economic growth, can flourish.

So how can you use interest rates to your advantage?

There’re a few ways that you can use interest rates to your advantage when it comes to investing.

1. Be aware of the numbers
   
   You don’t need to follow every report on interest rates. But having an idea of their general pattern and market commentary can help you to understand where interest rates might go. The BoE’s committee meets regularly and any changes to interest rates are reported. So you could follow this along with any updates if you fancied it.
   
   
2. Don’t panic
   
   Remember that interest rates can move up and down and so can your investments. Short-term fluctuations don’t necessarily mean that the long-term outcome will be the same. Keep that in mind before you make any rash decisions. And make sure you’re happy with how adventurous (or maybe not so) your investments are.
   
   
3. Watch the investment horizon
   
   Staying on top of moving interest rates can get you feeling uncertain about the future. But having a long-term outlook on your investments will help to push away the grey skies.
   
   Investing can feel like you’re trying to predict when the sun will come out on a rainy day. But if you stick around long enough, you’re more likely to see blue sky than if you move around trying to catch it.
   
   Keeping your money invested, and not cashing out when stock prices fall, can be testing for even the hardiest investor. But investing in diverse funds that are managed by experts, as well as being a regular investor, can help you find the sunshine on the horizon.

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