The Impact of Interest Rates on Investment Decisions

Have you ever noticed that after the RBI meeting about interest rates, the stock market displayed a sudden spike or downside movement?

Well, if yes then two words are responsible for this movement:

“Interest Rates”

Imagine the economy as a car, where the money supply acts like the gasoline that keeps the engine running smoothly. Now, think of interest rates as the lever or gear shift that controls how much fuel flows into the engine.

When interest rates change, it’s like adjusting the amount of fuel going into the engine—this can make the economy speed up or slow down, affecting how businesses grow, how people spend their money, and how well the economy as a whole performs. In simpler terms, just like shifting gears in a car changes how the car moves, changes in interest rates can shift how the economy “moves” and behaves. 

Understanding Interest Rates

In simple words, Interest Rate is the price that you pay for borrowing money from the lender. When you borrow money, you have to pay back some extra money as an interest including the money you borrowed. That extra money is flexible and set according to the Interest rate set by the national bank. In India, the Reserve Bank of India(RBI) is responsible for declaring Interest Rates.

Interest rates and the stock market and closely related. Changes in Interest rates may have a significant impact on the stock market and financial Institutions. Interest rates can create differences in a company’s performance and stock prices.

Why do banks change the Interest Rate?

Inflation is the primary reason for changing the Interest rates.

Inflation, in simple words, is the rate at which goods and consumer prices increase.

For example, the current inflation rate in India is 5.10%. This means prices are 5.10% higher than they were a year ago. A Rs. 100 product 12 months ago would now cost Rs. 105.

Inflation is highly dependent on supply and demand. You can understand it with a very basic real-life example: if demand for any product rises, it increases the prices of that product. If demand increases, it increases the inflation rate.

If the central bank thinks inflation is rising too quickly, it may increase the increase rates. It then costs more to borrow money so people may be discouraged. When interest rates go up, borrowing money becomes more expensive. This might make people borrow less and save more. As a result, there might be less demand for some things, which could help slow down inflation. 

In the same way, when the central bank feels the rate of inflation is too low, it may bring down the interest rate to boost the economy. When interest rates are lower, it may encourage people to borrow and spend money rather than save it in the account. This increases the demand for products and leads to a rise in inflation.

How do Interest Rates affect the stock market?

Interest Rates and the stock market always move in the opposite direction. Corporate profits heavily depend on interest rate movements.

Let’s understand in simple words:

Growth Companies usually borrow from banks to increase their business flow. They need to pay back the loan quarterly with an interest rate. If the interest rate is higher, it will require more money to pay back the money. This will be reflected as negative in the quarterly results of the company. If the company is performing negatively in its results, it will ultimately bring the downfall of stock prices.

On the contrary Value stocks are shares of established companies that regularly pay steady dividends. These companies remain popular even when people are spending less money.

Additionally, stocks from the financial sector like banks, mortgage lenders, and insurance providers may increase in value when interest rates go up because their expected earnings rise.  Investors often prefer value stocks over growth stocks as they are less risky, offering lower returns and dividends that are satisfactory to investors. 

How do Interest rates impact your finances?

Interest rates may have an important impact on your Investment and finances in different ways:

1. Borrowing costs:

When interest rates go up, borrowing money using loans, credit cards, or mortgages becomes more expensive. This results in paying more interest overall and possibly higher monthly payments. To manage this situation, it’s beneficial to focus on paying off your debts when interest rates are high. 

2. Earning on Savings:

You can get more returns on your savings during higher Interest rates. Higher rates can benefit your savings accounts or other interest-bearing accounts.

3. Investment Returns:

The stock market typically declines when interest rates increase. The purchasing capacity of people decreases they tend to spend less. Companies hire less or may have layoffs due to lower productivity and reduced earnings. You can get losses in your investments and portfolio due to the fall of the stock market.

4. Retirement Planning:

Interest rates may impact your retirement planning. As the interest rates are higher, the return on investment in your retirement account may be affected. Low rates can create difficulty in generating the necessary returns to fund your retirement.

5. Student Loans:

If you have student loans, then higher interest rates can affect the total cost of your education. Student loan interest rates are generally tied to market rates, so they can be changed over time.

6. Refinancing Opportunity:

Change in Interest rates can create opportunities for refinancing existing loans. During lower Interest rates, you can finance your home loan and you will have to pay lesser Interest rates. A rising rate will limit your capability to refinance your desirable item.

Bottom Line on Interest rate and your Investment

Interest rate fluctuations can affect your investment goals in different ways. But these fluctuations are usually temporary.  If you are a long-term investor, then the interest rate will not affect your portfolio much.

Stay focused on your Investment goals, and stick to your plan. Diversity in your portfolio will save you from these temporary fluctuations.