Interest, interest, interest! Everyone hears that word thrown around everywhere when it comes to money. But do people know what it actually means and how interest rates affect investments? Keep reading to learn more!
What is interest rate?
Interest rate can be looked at as a reward/loss system in which the rate tells one how much money they’ll incur on their savings OR how much money will build up and be tacked onto the money they need to pay back.
Interest can be looked at from 2 different perspectives: being a saver or a borrower.
If you happen to be a borrower, the interest rate is the amount you are charged for borrowing money, shown as a percentage of the total amount of the loan. The bigger the percentage, the more money you have to pay back- this is referred to as interest building up on the money you borrowed. The longer one takes to pay back their loan, the higher the total interest cost becomes on said loan!
If you’re a saver, the savings rate tells you how much money will be paid into your account, as a percentage of your savings.
How do interest rates affect investments?
When the Federal Open Market Committee, FOMC, makes a change in the Federal Funds rate (target interest rate set by the FMOC), the impacts are seen not only in the stock market but also in the economy. Borrowing money becomes more or less expensive.
Higher interest rates tend to negatively affect earnings and stock prices. As rates rise, businesses are not only impacted by higher borrowing costs but they are also exposed to the adverse effects of flagging consumer demand. Both of these factors can weigh on earnings and stock prices.
A decrease in interest rate has the opposite effect than that of an interest surge. ○ Investors and economists view lower interest rates as catalysts for growth—a benefit to personal and corporate borrowing. This, in turn, can lead to greater profits and a robust economy.
When lower interest rates occur, consumers feel as if they’ve won the jackpot because now they’ll be spending less money to accomplish things such as buying a house. This can lead to higher stock prices
Are there any risks associated with investing in a market with changing interest rates?
To answer this question we need to learn about a key term interest rate risk! Interest rate risk is the potential for investment losses that result from a change in interest rates. In other words, if interest rates rise- the value of fixed-income investments or bonds will decrease, and vice versa.
Interest rate risk can be reduced through diversification of bond maturities. For bonds that have a fixed rate, when interest rates rise to a point above that fixed level, investors may switch to investments that hold a higher interest rate.
When it comes to bonds and changing interest rates, it’s key to account for the following risks associated with investing in them during a period of changing interest rates:
Interest Rate Risk:
- Risk that the value of a loan will change due to fluctuating interest rates
- If an interest rate increases, businesses with loan debt will have to pay more
Credit Risk:
- The risk a business takes when it provides a loan, product, or service without payment upfront
Liquidity Risk:
- A risk primarily faced by businesses
- When a business has assets that may not be able to be sold for their true value or for a profit
Inflation Risk:
- The risk that your purchasing power will be reduced if the value of your investments does not keep up with inflation
- Investing involves risk, including possible loss of principal
- Bonds are subject to market and interest rate risk if sold prior to maturity
- Bond values will decline as interest rates rise and bonds are subject to availability and change in price
- There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio.
- Diversification does not protect against market risk.
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