Brief Overview of Interest Rates
Interest rates are primarily the amount lenders charge to borrowers who have taken loans or assets for use. So what is the relation between investing planning and variations in interest rates? In case of high interest rates, the cost of borrowing tends to surge making it difficult to borrow money for investment purposes. These rates are generally determined by central banks committed to maintaining a target interest rate. For instance, the rates in the US are set by the Federal Bank and in India they are set by the Reserve Bank of India. Here we will discuss about the effect of interest rates on investment. Let us first learn about different types of interest rates, which are explained below.
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Understanding the core concepts of Interest Rates
You may come across various types of interest rates, however, you should know about these three namely Nominal Interest Rate, Real Interest Rate and Effective Interest Rate. Let us learn a little about these three.
The Nominal Interest rate is the rate that is considered before taking inflation into account. “Nominal rate of return = Current Investment Value/Original Investment Value – 1” this formula calculates the nominal interest rate.
The Real Interest Rate is calculated after taking inflation into account. It can be calculated by deducting the inflation rate from the nominal interest rate. Since this interest rate considers inflation it focuses on the purchasing power of money which is impacted by changing inflation rates.
The Effective Interest Rate takes compounding into consideration for a given period of time. The formula for calculating this interest rate is “Effective Interest Rate = (1 + Stated Annual interest rates / Number of Months) ^ Number of Months -1”
The factors impacting the determination of interest rates include tax consideration, credit risk, and time and loan convertibility.
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Effect of interest rates on investment
Interest rates impact most asset classes including stocks, bonds and gold. With an increase in interest rate, the stock market declines due to increases in the cost of borrowing and a decrease in consumer spending. Hence, there is an inverse relationship between interests and the stock market. A similar relationship is observed between interest rates and other assets such as bonds and gold. However, the price of real estate increases with a surge in interest rate due to growth in buying cost of buildings.
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Impact of rising and falling interest rates
Rising interest rates are challenging for a country with economic downturns and business slowdown possibilities. This hinders the revenue-earning capabilities of companies, triggering a decrease in stock prices and eroding investors’ wealth. However, increasing interest rates facilitates growth in return on savings and controls rising inflations.
Decreasing interest rates supports business and consumer spending leading to growth in asset prices. Expanded asset value and customer spending increase the profit margins of different enterprises, increasing stock market performance and investors’ wealth. However, extensive interest rates could lead to a surge in the inflation rate raising the possibility of liquidity traps.
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Strategies for Investors
The most optimum strategy for mitigating the effects of interest rate on investments is to wait! Yes, holding your assets for the long term can easily navigate the risk of wealth erosion regardless of interest rate fluctuations. Interest rates have different levels of impact on different types of assets, therefore, diversifying investments into different asset classes is helpful for effective risk management. Focusing on the interest rate trend is another crucial strategy for planning your investment and preparing effective allocation for an optimum portfolio. You can also use interest rates future, options and other heading strategies risks of fluctuating interest rates on your investments journey.
