Library: Economics

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What are Interest Rates?

And how do they affect the way I invest

Interest rates are all around you. Your buying decisions are based on them. Your savings decisions are based on them. Sometimes even without your knowledge. If your credit card interest rate were to go up from 25% to 45%, chances are that you would think twice before buying that new laptop.  Similarly, if interest rates in your savings account gave you 4%, but another investment guaranteed you 12%, you’d probably go for the 12%.

Investments ain’t no different

Believe it or not, investments are no different. Interest rates affect how you choose to invest. For instance, you might invest prudently rather than spend on consumables (fancy word for consumer products like TVs, cars, iPods…etc.) if interests rates for credit cards and loans go up so much that you’re struggling to make the minimum payments. In a different scenario, your savings account’s interest rate could decrease so dramatically that it could force you to find a different means to grow your money. Enter investing.

When interest rates go up, investment in the stock market goes down

This happens for two reasons. The first one is because the increase in the interest rate makes your savings account look cozier. The bank guarantees it, and you’ll earn more now, so why take the risk of the stock market?

The second reason is because people stop taking out loans, as the rates are too high. Fewer loans mean less spending. Companies make less money, people buy fewer stocks, and the stock market suffers.

When interest rates go down, Buy Buy Buy!

When interest goes down, you should buy buy buy stocks.When interest come down, the stock market gets a boost. The reasons are directly opposite to when rates rise. If you woke up and saw a ridiculously low rate of interest on your savings account compared to yesterday, what would you do? The stock market should cross your mind. It’s more risky, but it can also be more rewarding.

Also, as interest decrease, people often use their credit cards and lines of credit more, because they think they’re getting a bargain (“Buy now, and pay nothing for 10 months!” Or “Get our limited time 0% financing offer!”). This causes companies to sell more, bag more profits, and increase their stock price.

How to use interest rate fluctuation to your advantage

You can actually make money on changing interest rates by following the news. As soon as you hear of a plan to cut interest rates, you should buy stocks in the S&P 500.

To practice this technique, make some trades on Wall Street Survivor.

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