Interest rates can influence all aspects of our financial lives, including mortgages, car payments, and credit card bills. When it comes to investments, these rates can impact everything from bonds and savings to the stock market and real estate transactions. 

Understanding how interest rates can affect investments can mean the difference between running out of money in retirement or having a large nest egg to draw from. This article will discuss various types of interest rates, how they work, and their effect on specific classifications of investments. 

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What are interest rates, and how do they work?

Interest is the price you pay to borrow money or what you earn when you save or invest. When you borrow money, the interest rate is the percentage of the principal a lender will charge you for your debt. For example, when you have a balance on your credit card at the end of the month, your creditor will add interest to what you owe. 

When you save or invest money — such as when you put funds in a savings account, a certificate of deposit, or an annuity — the financial institution will pay interest according to the account terms. 

There are two primary ways to calculate interest:

• Simple interest: Interest is calculated based solely on the principal amount. For example, if you invest $1,000 at a 5% simple interest rate, you'll earn $50 yearly, no matter how long you keep it invested.
• Compound interest: This is calculated on both the principal and any accumulated interest previously earned. For example, if you invest $1,000 in a 5% fixed annuity, the cash value will be $1,050 after the first year (a $50 gain). But at the end of the second year, it will be worth $1,102.50 (a $52.50 gain) since the first year’s interest is part of the second year interest calculation. 

There are two common types of interest rates: 

• Fixed interest rates: These interest rates stay the same over the period you’re repaying a loan or earning interest on a savings product. 
• Variable interest rates: These fluctuate over time, meaning you could pay or earn more(or less) interest depending on market conditions.

How interest rates affect different types of investments

Interest on an investment can be considered a reward. But rates can impact your returns in different ways. A decrease in rates may be favorable to some investments but reduces the value of others. 

Bonds

Bonds represent government or corporate debt. They typically pay regular interest over a set period, but their value moves inversely to the interest rate. For example, if you buy a $10,000 bond that pays 4% annually — $400 every year — and rates move to 6%, your bond typically decreases in value. That’s because newer bonds will offer $600 annually for the same investment. So investors won’t want to buy your bond, which would only pay $400. 

Stocks

Stock represents a portion of a company's ownership. Stock prices typically do well when the company is prosperous. But when interest rates rise, borrowing costs increase, which can lead to higher expenses that reduce profits and slow growth. This can result in lower stock prices. 

Savings and certificates of deposit

Traditional savings accounts and certificates of deposits (CDS) are two ways to preserve your capital. When overall interest rates increase, many banks raise the annual percentage yields (APYs) on these accounts. This gives you access to higher interest over time. When rates fall, banks offer smaller APYs. 

Banks typically offer CDs with fixed APYs. If overall rates rise after you open a fixed-rate CD, newer certificates will likely offer better APYs, making your current CD less competitive. But if rates fall after you’ve locked in a CD, the money in your account will continue to grow at the original rate because it’s shielded from the erosion of lower interest rates. 

Real estate

The real estate market is sensitive to interest rates since most residential and commercial investors calculate their purchases based on monthly payments. Higher interest rates reduce buying power, but lower rates make more expensive properties attainable. 

Consider a homebuyer who has $3,000 per month budgeted for their 30-year fixed rate mortgage payments, including property taxes and homeowners insurance. Using a mortgage calculator, you can see if interest rates are at 7%, they can afford a home valued up to approximately $400,000. But if interest rates fall to 6%, they can now afford a home worth up to approximately $430,000. 

Commodities

Commodities are globally traded physical goods like oil, gold, and agricultural products. Investors aim to make money with contracts that allow them to buy or sell these commodities when the market moves. When rates are high, investors often back away from commodities since the cost of borrowing is higher.

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Effects of low vs. high interest rates on the economy and investing

The Federal Reserve (the Fed) uses the federal funds rate — what banks charge each other for overnight loans — to control inflation, stabilize the economy, and promote growth. When the Fed determines that the costs of goods and services are rising due to inflation, it increases interest rates to slow down spending. When unemployment is high or the economy becomes stagnant, the Fed lowers rates to encourage borrowing and spending. While the Fed funds rate only applies to financial institutions, other interest rates — like bond rates, CD rates, and annuity rates — typically follow suit when it moves.

What determines interest rates in the U.S.?

The Fed uses multiple factors to determine which direction the Fed funds rate should move and by how much:

• Inflation: If the cost of goods increases too rapidly (inflation), the Federal Reserve may raise interest rates to slow growth.
• Employment: If there’s a weak job market, the Fed might lower rates to stimulate hiring and make business expansion more affordable. 
• Economic growth: The Federal Reserve attempts to keep the economy growing steadily without accelerating it. 

Beyond the Fed, market forces also play a role. Supply and demand for credit and borrower creditworthiness can influence the rates offered on personal loans, mortgages, and investment products.

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FAQ

What is a high interest rate?

High and low interest rates are relative terms. A high interest rate for a mortgage would be considered a low interest rate for a credit card. Whether you’re shopping for investment products or financing a car or home, you’ll want to focus on whether the interest rate is competitive compared to similar products. Gainbridge annuities have competitive interest rates and minimum  contribution amounts as low as $1,000. 

How are interest rates determined?

The Federal Reserve sets the fed funds rate. Financial institutions then set their rates based on risk, profitability, and competitor rates. 

What effects do low interest rates have on the economy?

Low interest rates encourage borrowing and spending, which can help the economy grow. However, if interest rates are held low for too long, they can lead to inflation.

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This article is for informational purposes only. It is not intended to provide, and should not be interpreted as, individualized investment, legal, or tax advice. For advice concerning your own situation please contact the appropriate professional. The Gainbridge® digital platform provides informational and educational resources intended only for self-directed purposes.