How Does Raising Interest Rates Impact Financial Investments?

Kreg Bale
Kreg Bale August 10, 2022
Updated 2022/08/10 at 2:27 PM
interest rate and investment relationship

The base rate of interest in the UK has been raised five times since December, increasing from 0.01% to 1.25% and its highest level for 13 years. 

The decision to initiate five such monetary policy changes has largely been inspired by rampant inflation, which soared to 9.4% in June and is projected to reach 12% by October this year.

With interest rates primed to increase even higher in the months ahead, we ask how this impacts the stock market and broader portfolio of financial investments.

Rising Interest Rates – An Overview

The base interest rate is set by the Bank of England (BoE) during their frequent monetary policy meetings, with this setting that rate at which banks and other lenders are charged when they borrow money. 

As a result, this impacts the subsequent rates of interest applied to savings accounts, credit accounts and mortgage agreements, increasing the cost of such financial products in the process.

In general terms, increasing the base rate directly hikes the total cost of borrowing, as lenders need to apply higher rates of interest to their loan agreements and products in order to maintain a viable profit margin.

Once higher rates of interest have been applied, borrowing becomes significantly more expensive and businesses (and individual consumers) are discouraged from investing or spending in the economy. 

Of course, banks and lenders have a habit of optimising the cost of loans while minimising savings rates as the base rate rises, so each hike may impact your differently. So, it’s important to liaise with experts to understand how a rise in the base rate impacts on your investment portfolio and loan agreements. 

How is the Stock Market Impacted?

As the cost of borrowing increases and businesses are deterred from seeking out loans to help grow their ventures, it’s not uncommon for growth to stall.

It can decline in instances where inflation remains stubbornly high and interest rates continue to rise, as both individual sectors and the wider economy continue to suffer adverse effects.

From an individual business perspective, growth cutbacks and squeezed profit margins have a habit of restricting cash flow, with these issues further compounded by reduced consumer spending.

Because of this, individual company share prices tend to depreciate, while even major indexes like the FTSE 100 in the UK could see their values tumble if the decline is experienced across a number of different sectors.

The good news for investors is that other assets aren’t so adversely affected. For example, bonds tend to see their prices fall when interest rates rise, creating an opportunity for investors to cash in on newly issued bonds at this time.

Of course, existing bonds with low coupons that were issued during periods with lower rates will subsequently be worth less, and it’s important to keep this in mind depending in the nature of your portfolio.

The Last Word – What About Mortgages?

If you also own a home and a variable mortgage tariff, you’re likely to see your monthly repayment increased in instances where the base interest rate continues to rise.

This is directly due to the increased cost of borrowing, as lenders look to offset their higher capital outlay and pass this directly onto consumers.

Naturally, periods of higher interest rates tend to see a decline in demand for mortgage and similar loans, causing further disruption to consumers and particular business types in the marketplace.

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