What happens if the interest rate increases?

Increasing the interest rate is not good news for consumers, mortgages and loans cost more. But there are also opportunities like yields on bonds and government bonds are growing. For some years now, we had grown accustomed to very low-interest rates to historic lows. The economy is struggling to recover, and showing worrying signs of recession needs low rates to stimulate recovery. When borrowing costs too much, people don't borrow money to make purchases, and businesses also avoid investing. In this way, the economy cannot grow. When, on the other hand, interest rates are low, it is easier to take on debts and be able to repay them. The mortgage installments will be lower, and so will the consumer credit installments because all types of financing are based on interest rates. With rising rates, the installments of new mortgages and loans become more expensive; only those who had previously contracted a fixed-rate mortgage are saved. So you are forced to give up financing because the cost to pay is too high compared to income. 

The cost has increased; the installment we have to pay for the loan goes up. If it is too expensive, we can no longer afford the loan or mortgage. If we have already had it, there are difficulties in repaying. We must regulate ourselves in the choices and financial planning and know first what if the interest rate increases? What does it mean for our savings, for consumption, and if there are opportunities for convenience when we go to ask for a loan. In fact, if we are savers, the rise in rates entails greater possibilities of return and, therefore, of profit from our investments. 

If we lend money instead of borrowing it, rate hikes can be good news. So let's see what the interest rate is, when and why it drops or goes up and what consequences these movements have on our habits and financial decisions. Is it possible to predict and anticipate the movement of rates? How should you invest in a rate hike period? Which securities to buy, which to keep or sell? It is appropriate or not at this time to ask for a mortgage for the purchase of a house or a loan for consumer goods. Let’s have a look at what happened if the interest rate increases.

What is the interest rate and what does it measure

The interest rate is the cost of the money that lends itself. Those who offer money want compensation, I give you 100 today, and you will return 105 in a year. That is to say; you will repay the principal I have lent you plus 5% interest, which represents my remuneration for having lent you the money and having waited for its return for a year.

This is why the interest rate is also called the “price of time. " The longer the loan period, the higher it’s cost because those who have lent themselves will be paid more for having renounced the availability of their money for a longer time. 

It is necessary to give them adequate remuneration to convince people or businesses to lend their money to banks or the State. The interest rate measure and this price increase with the increasing duration of the loan. With the same amount, a term loan of five years will serve a higher interest of a repayable in two years. Even if the installment in the first case will be lower, the total amount that will be returned will be higher.

Each period of time has its own rates; there are short-term and long-term rates. Usually, the longer the deadline, the higher the rates applied.

The bank convinces savers to deposit their money by offering a certain interest to make it cheaper to use it in this way rather than keeping it under the mattress or investing it in other ways, such as buying real estate or equity investments in companies.

The State also offers its public debt securities on the market to finance itself and, in exchange, promises the subscribers to repay the capital plus a certain interest.

But how is this interest determined? Its rate is determined based on another fundamental value, which is the inflation rate.

Nominal rate and the real rate

The congruity of an interest rate - that is, its effectiveness in measuring the cost of our loan or the return on our investment - must be measured, taking into account how much inflation has grown in the meantime. We refer to the future, that is, if we want to evaluate the convenience of a loan to be requested or an investment to be made now, and which will last a few years, we must relate to the expected inflation.

The interest of 15% per annum seems high, but if inflation in that year were 20%, we would not have gained at all, but we would have lost 5% of our capital.

In the end, in fact, the sum of 115 would not be enough to cover the inflation that had accrued in the meantime. They raised prices to buy the same things for which the year before we needed 100 dollars, now we need 120, and we only have 115.

Our money will have less purchasing power, that is, with that amount you will be able to buy fewer goods because their prices have grown because of inflation.

It is necessary to distinguish the nominal rate from the real rate, that is, the rate excluding inflation.

To calculate the real interest rate, it is necessary to subtract the inflation rate from the nominal interest rate, that is, the one agreed or promised in the loan agreement or in the subscription of the bond. If our bond makes 5% per annum and inflation it is 2% per annum, the real interest rate will be 3%.

From here, we have the measure of the true cost of our loan or the actual return of our investment. The good news is that the growth of interest rates at this time is not accompanied by a similar increase in the inflation rate. We will pay more for the money we borrow, but on the other hand, we get a higher real remuneration if we lend it, to invest it in financial products. This investment guarantees an adequate return in real terms.

When and why does the interest rate go up?

Rates rise (or fall) when economic conditions vary, and the economic and political scenario changes. The factors are many such as corporate health, political tensions, and employment trends. In a nutshell, when the risk increases (not only the real one but also the "perceived," i.e., the fears), the price that money lenders ask for increases the interest rate.

We have seen that if rates go up too much, the capital holders are no longer willing to lend it. Even the loan applicants are not willing to pay too high interest, and all this is bad for the growth of the economy. For this reason, central banks intervene with all the tools available to them to keep rates as low as possible or at least to an acceptable level. They intervene on interest rates mainly on the basis of inflation trends. When this tends to rise, central banks raise interest rates to discourage expenses; in this way, financing costs more, and it is more difficult to buy products such as cars or household appliances. 

Thus consumption decreases, and prices do not rise. On the other hand, when inflation falls, they lower rates to encourage purchases, consumption, and investments.

This is what has happened in recent years; both the ECB (European Central Bank) and the FED (the US Central Bank) have adopted policies that have "forced" all banks and financial operators to keep the interest rates applied to customers within certain limits.

Central banks have acted on the interest rates of government bonds, which are mainly purchased by financial institutions. Their yield over the past three years has even been negative with regard to short-term ones.

In this way, we wanted to discourage the use of capital in "safe" government bonds to divert it towards loans and, therefore, investments and consumption that bring economic growth. Above all, the European Central Bank, with the presidency of Christine Lagarde., has decided to adopt this extremely low rate policy to encourage banks to lend money to businesses and families. However, there have been recent warnings, even official ones, that this policy so far held by central banks is about to end. There is a danger that rates may rise in the near future.

In fact, as the markets anticipate trends, there has already been a generalized growth in interest rates, mortgages, and loans cost more than in the recent past. Also, the yields of government and bond securities have gone up. We must evaluate how to behave in this scenario whether you are a consumer or an investor. You need to know what the right moves to make are if you decide to apply for a mortgage or a loan for the purchase of a consumer good or if you intend to invest your savings in bonds or government bonds. 

Before going into detail, remember well this concept, interest rates are very sensitive to the trend of inflation. So when this goes up, the rates go up, and vice versa.

So far, central banks have tried to counter the rise in inflation using the weapon of interest rates, which have been kept very low through a specific monetary policy, which will probably not be continued in the future. Interest rates could go up, and we have to deal with this eventuality, especially considering whether it is better to get into debt or invest now or to wait.

How to invest with rising rates: risks and opportunities

The increase in interest rates represents a risk for those who have borrowed money and will have to pay more when they return it, while it is an advantage for those who offer it. We often forget that it is not only banks that offer loans that lend their money, but also individuals who invest their savings. They, too, offer their capital to those who request it, such as companies that issue bonds or even the State itself, which periodically auctions its securities.

So you too, if and when you buy a government bond or a bond issued by a company, are lending money, and in return, you will have an interest rate as remuneration. It will measure your earnings and the return on your investment. The market conditions of that moment are expressed by the trend in interest rates. It is measured daily and periodically, 3 months, one year, 5 or 10 years, and even at 30 or even 50 years. Each of these periods has its own index, which measures the trend of interest rates.

As government bond auctions show (at least a couple of them a month), interest rates and returns are very fluctuating over time. 

So, in the same way, if you request a quote for a loan today and then return after a few months, you may find that the conditions have changed considerably. The increase in interest rates has changed, in practice, the number of installments to be paid. Sometimes the amount to be repaid has grown so much, compared to your income and your assets, that you are forced to give up the loan because you would not be able to repay it.

Let's now look at these two aspects in more detail. If you are on the side of those who need to request money on loan, you will need to know the consequences of rising rates on mortgages. While if you are on the side of those who want to invest in bonds and securities, they will be useful to know the factors that can increase your expected return.

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Author: Vicki Lezama