How interest rates affect investments

Interest rates help determine both the cost of borrowing money and the reward for saving money. Higher or lower interest rates can have a ripple effect throughout the economy, including on your investments.

Let’s dive into what interest rates are, the different types of interest rates, and how they affect your savings and investments.

What is interest?

Interest is a term that can refer to both the cost of borrowing money and the return earned on an investment.

When you borrow money from a financial institution, you’re obtaining a loan in exchange for a small fee, which is the interest you pay to the financial institution. And when you invest money in a savings account, bond or other money market product, interest is the return you receive on your investment.

There are two main types of interest: simple and compound.

• Simple interest is the interest is calculated only on the principal (original) amount of the investment or loan. This means that the interest you pay (or earn) remains the same each period.
• Some investments offer compound interest, where the interest earned in one period is added to the principal investment, and then interest is calculated on the new total. In other words, the interest you earn compounds over time, leading to potentially higher returns, especially if you have a longer investing timeline. 

What are interest rates?

The interest rate is the percentage that dictates how much interest you’ll pay or earn on a financial product.

A higher interest rate means you’ll pay more to borrow money or earn more on an initial investment. A lower interest rate means you’ll pay less to borrow or earn less interest on your investment.

Interest rates are influenced by several factors, one of which is your “creditworthiness.” A bank or other entity may look at your FICO credit score, bank statements and other financial documents before deciding what interest rate to offer you. If you have a good credit score, for example, you may be viewed as more likely or able to pay off your debt and therefore qualify for a lower interest rate.

Interest rates can be fixed or variable.

• Variable interest rates can change over the length of the loan depending on market conditions, which means your payment may increase or decrease at different times.
• Fixed interest rates are locked in for the length of a loan and cannot change. 

Common types of loans and their interest rates

Here are three common loan types and how their interest rates compare.

• Mortgages and auto loans typically have fixed interest rates. There are also a small number of home mortgages called adjustable-rate mortgages (ARMs), in which the interest rate can fluctuate throughout the length of the loan. That said, ARMs often have a period of fixed interest before they fluctuate.  
• Credit cards and home equity lines of credit (HELOC) often have variable interest rates, meaning the amount you’ll pay each month may vary based on market conditions. Variable interest rates may be beneficial when interest rates are declining, but when interest rates rise, you’ll pay more. Variable interest rates can also make it harder to budget, as you won’t have a set amount to plan for each month.
• Student loans. Student loans are usually fixed-rate loans, but if you apply for a private student loan, you may be offered a variable rate. 

Short-term vs long-term interest rates

Short-term and long-term interest rates are based on the time frame of a loan or investment. Both can be either variable or fixed.

• Short-term interest rates. These apply to savings accounts, money market accounts and certificates of deposit (CDs) with shorter time frames. Short-term rates are generally influenced by central bank policies (notably the Federal Reserve) and current economic conditions. They’re typically lower than long-term interest rates but more sensitive to short-term fluctuations.
• Long-term interest rates. These apply to loans and investments with extended borrowing periods, such as long-term bonds (10+ years) and 30-year fixed rate mortgages. Long-term rates are influenced by the economic outlook and inflation expectations, among other factors. They’re usually higher than short-term interest rates to make up for the potential of greater risk over time.

How interest rates influence bonds and stocks

Interest rates and bonds have an inverse relationship: When interest rates rise, bond prices fall, and vice versa. However, not all bonds are affected equally. Bonds with shorter maturities may be less affected by interest rate fluctuations, while bonds with longer maturities will generally be more affected.

In contrast to bonds, stock prices are not directly affected by interest rate changes.

When interest rates rise, banks often increase loan costs for consumers and business loans, which can reduce spending and lower stock values. Higher interest rates may also lead companies to halt business expansions and put a pause on hiring, which could also lower a stock’s value. However, there’s no guarantee that an interest rate change will affect stocks.

Read more about how changing interest rates impact the bond market and the stock market.

How interest rates affect savings and other investments

It’s also important to consider how rate changes might affect elements in your portfolio other than stocks and bonds.

• Savings accounts and CDs. Savings accounts and CDs can act as a buffer against more volatile investments like stocks. CD and savings account rates are generally more favorable when short-term interest rates are higher and less favorable when they’re lower.
• Commodities. Commodity prices may fall when short-term interest rates rise, while lower interest rates may be more favorable toward commodity prices.
• Real estate. Real estate prices are closely linked to interest rate markets, in part due to the cost of financing (mortgage rates) and in part due to some bond-like characteristics, such as regular income payments. Like bonds, the relatively steady stream of income that real estate generates becomes less attractive as interest rates and coupons on newly issued bonds rise.

Interest rates and long-term investment strategy

Interest rate fluctuations are a normal part of the economic cycle, affecting savings and investments in various ways. As such, there is no single action you should take when they change.

However, there are actions you can take to manage potential interest rate risk. One strategy is diversification. Spreading your investments across asset classes that respond differently to interest rate changes may help you reduce the impact on your overall portfolio.

For bond investors, laddering can be an effective tool. This involves buying bonds with different maturity dates. When short-term bonds mature, you can reinvest the cash. If rates have risen, you reinvest at higher yields. If rates have fallen, you still have long-term bonds locked in at the older, higher rates. This approach helps balance both interest rate risk and reinvestment risk.

Ultimately, your investment strategy should align with your financial goals and timeline, not just the current rate environment. Rates will change, but a diversified portfolio helps you stay on track regardless of which direction they move.

From investing online to working with a financial professional, learn more about your investing options.