What Are Interest Rates and How Do They Affect Markets?

It is safe to assume that whether on the news, on social media, or from your financially enthusiastic friend, one way or another, you might’ve heard of interest rates.

They are key economic figures that should be comprehended and studied to better tackle the economy.

Accordingly, this article will explore interest rates, what they are, and how they can affect your trading portfolio.

TL;DR

• An interest rate is the percentage earned on saved money or paid on borrowed money—banks use it to incentivise saving or profit from lending.

• Higher rates mean more savings earnings and higher loan repayment costs. Lower rates make borrowing cheaper, but saving less rewarding.

• Interest Rates include Fixed Interest Rates, Variable Interest Rates, and Annual Percentage Rates (APR).

• Interest rates influence inflation, recession, consumer spending, industry growth, and economic stability.

• Higher rates usually hurt stock prices; lower rates support growth.

• Higher rates usually lead to a stronger currency and lower commodity prices.

• Lower rates usually lead to a weaker currency and higher commodity attractiveness.

What Is an Interest Rate?

An Interest Rate can be the percentage you’ve earned from the money you saved or owe your borrower. For example, if you take out a loan from the bank, then the interest rate is the percentage of the money you need to pay the bank in return for granting you the loan. On the flip side, if you save up money in a savings account, the interest rate is the percentage you’ve earned in response to saving money. This is perhaps why many banks use interest rates to incentivise customers to open savings accounts.  

How Do Interest Rates Work?

Since an interest rate is a percentage of the amount of money saved or borrowed, the overall price of the loan or savings is affected by it. Accordingly, higher interest rates mean you earn more money from your savings. On the other hand, higher interest rates mean you need to pay more money to your lender. (Source: Bank of England)

What Are the Different Types of Interest Rates? 

Interest rates are of three types: Fixed, Variable, and Annual Percentage Rate (APR).

Fixed Interest is considered one of the most common types of interest rates. This type of interest usually refers to the money a borrower has to repay their lender in return for the loan. As the name entails, this type of interest is fixed, i.e. predetermined and stable, and is usually decided on before the inception of the agreement between the lender and the borrower. 

When discussing Variable Interest Rates vs. Fixed Interest rates, as opposed to the latter, which are stable in value, Variable interest rates fluctuate over time based on periodic changes in an underlying benchmark interest rate or index. This means that if the underlying index or interest rate depreciates, then the amount of money you owe your lender decreases. In a similar vein, if the underlying index or interest rate rises, then the amount of money you owe your lender increases. 

Lastly, the Annual Percentage Rate (APR) is the amount of interest you pay on a yearly basis in return for borrowing money. In addition to the interest, the APR includes the fees one has to pay in order to borrow money. Thus, the higher the APR, the more you'll pay over time. Moreover, this type of interest is popular among credit card companies.

Why Do Interest Rates Matter and How Do Interest Rates Affect Inflation?

The main significance of interest rates is that they directly impact inflation, deflation, and recession. In times of high inflation, like those recently observed around the globe, central banks raise interest rates to combat it. 

Additionally, interest rates are important because not only do they affect borrowing costs and financial decision-making, but they also shape the economy in that Interest Rates alter the formation of labor and resources. In other words, industries’ growth, shrinkage, and financial deployment are affected by Interest Rates.

The Impact of Interest Rate Changes on Markets

While past performance does not reflect future results, historically speaking, the impact of interest rate changes is as follows:

Stock Markets 

Rising Interest Rates:

When interest rates climb, borrowing becomes more expensive for consumers and businesses. This typically reduces spending and investment, dampening corporate earnings and putting downward pressure on stock prices. Growth stocks—particularly in sectors like technology that depend on borrowing—are especially vulnerable. In contrast, financial sector stocks (e.g., banks and insurers) often benefit, as higher rates can widen their lending margins.

Falling Interest Rates:

Lower interest rates reduce the cost of borrowing, stimulating spending and investment. This tends to support corporate profits and drive stock prices higher. A clear example is the Federal Reserve's emergency rate cuts during the 2020 pandemic, contributing to a rapid market rebound.

Bond Markets

Rising Interest Rates:

Bond prices move inversely to interest rates. As rates rise, existing bonds with lower yields become less attractive, causing their prices to fall. However, new bonds are issued with higher yields, offering better returns to new investors.

Falling Interest Rates:

Existing bonds with higher yields gain value when rates fall, increasing prices. Conversely, newly issued bonds offer lower returns, which can be less appealing to investors.

Other Markets

Higher interest rates typically exert downward pressure on prices for other markets like commodities. This is mainly due to the increased "cost of carry"—the expense of holding and storing inventories—making it less attractive for investors and traders to maintain large positions. As storage becomes costlier, demand for inventories declines, often resulting in lower commodity prices. 

For markets like forex, when a country increases its interest rates, its currency often strengthens as higher yields attract foreign capital, boosting demand for the currency. On the other hand, lowering interest rates usually leads to currency depreciation since reduced returns make the country less appealing to investors, decreasing demand for its currency.

Conclusion 

In an increasingly inflationary and uncertain global economy, understanding interest rates is no longer just for economists or investors—it’s essential for anyone navigating personal finance, business, or trading decisions. Interest rates touch everything from your savings account to national economic health. Whether they’re rising to fight inflation or dropping to spur growth, the ripple effects are wide-reaching, impacting stock and bond markets, currency values, and even commodity prices. By learning how interest rates work, the different types, and their broader economic impact, you can make smarter financial choices and respond proactively to market changes.

FAQs:

What causes interest rates to rise or fall?

Central banks adjust interest rates to manage inflation, employment, and economic growth. Rates usually rise to curb inflation and fall to stimulate spending.

How do rising interest rates affect my mortgage or loans?

If you have a variable-rate loan, your payments will increase as rates rise. Fixed-rate loans stay the same but may be harder to secure at low rates during high-rate environments.

Do higher interest rates benefit savers?

Yes. Savers earn more on deposits when interest rates are high, making saving more attractive.

Are interest rates the same in every country?

No. Each country’s central bank sets its own rates based on domestic economic conditions.

How do interest rates influence inflation?

Raising interest rates cools down spending and borrowing, which helps reduce inflation. Lowering rates boosts economic activity, which can raise inflation if overdone.

What’s the link between interest rates and the stock market?

Higher rates generally reduce corporate earnings and consumer spending, hurting stock prices. Lower rates can boost both, driving markets up.

Why do currencies rise with higher interest rates?

Higher rates attract foreign investors looking for better returns, increasing demand for the currency and pushing its value up.

*Past performance does not reflect future results.