Things That Happen When Interest Rates Rise

Jun 06, 2023 By Susan Kelly

Increasing interest rates have a multiplicity of effects on one's financial situation. There are some optimistic perspectives, while others hold pessimistic views. If you know what is likely to occur, you will have an advantage when planning your finances to cope with the possibility of a hike in interest rates. When interest rates go up, the following are some of the things that normally take place:

The Cost of Borrowing Money Increases

When interest rates are higher, it will cost you more money to borrow. Your monthly payment amount is mostly determined by three things, one of which is the interest rate. The other two factors are the total amount borrowed and how long it will take to repay the loan.

Borrowers who have debts with variable interest rates are instantly impacted if there is a rise in rates. Payments for new debt may be significantly increased while existing loans with fixed rates would not be impacted in any way.

If you wish to borrow $300,000 over a period of 30 years, for instance, the amount you have to pay back each month is likely to climb dramatically as interest rates rise. Your interest rate is 2%, which results in a monthly payment of $1,108.86. On the other hand, if the interest rate is increased to 4%, the payment would climb to $1,432.25 per month, an almost 30% increase.

Consumer Demand Decreases

Consumers tend to spend less money when it is more expensive for them to borrow money. Unless they see a gain in income, they will see a decrease in their discretionary income due to the increasing interest rates. As a result of paying a higher total price for their acquisitions, consumers have less money to purchase other goods. When it raises interest rates, the Federal Reserve considers this "cooling" of consumer spending as the desired outcome.

Savers Earn More Interest

Increasing interest rates benefit individuals who have their money invested in savings accounts, money market accounts, or certificates of deposit. Banks raise the interest rates they pay on deposits to bring in new customers and keep the deposits of current clients.

When the Federal Reserve raises interest rates, the interest rates on savings and money market accounts follow suit within a month. On the other hand, the interest rates on your CD won't change until it matures. The interest rates on new certificates of deposit change according to market rates, the certificate's length, and the bank's financing requirements.

Stocks Become Less Attractive

When an investor can earn more income on bank savings and bonds, the appeal of investing in stocks is diminished. In essence, investors don't have to expose themselves to quite the same level of risk to make the same amount of money. Consequently, some investors liquidate part of their holdings and reinvest the proceeds in money market accounts, certificates of deposit, and bonds.

Bond Values Drop

The value of current bonds will decrease as a direct result of higher interest rates. When an investor can earn a better return on a newly issued bond, the demand for older bonds with lower interest rates decreases.

Even if the price is now lower, you will still get the entire face value of your bond if you hang on to it until it matures, even though it is currently trading at a lower price. That is not true with bond exchange-traded funds (ETFs) or bond mutual funds. They reevaluate their pricing daily depending on the current value of the bonds in their portfolio, and they rarely keep bonds until they mature.

Buying a Home Is More Expensive

The amount that homeowners can pay toward their mortgages every month is capped according to household budgets and underwriting criteria. As interest rates rise, it becomes more difficult for would-be homeowners to meet the financial requirements to purchase a house. The increasing interest rates make the required monthly payment for purchasing their property more expensive.

Many homeowners can no longer afford the market prices and are priced out of the market entirely unless sellers are prepared to accept lower offers. Because they have a restricted budget, they must purchase a smaller property, look in a different neighborhood, or make concessions on one of the other criteria. In certain instances, customers will hold off on purchasing until they discover a more favorable offer.

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