What interest rate changes mean for investing

There’s always lots of attention in the news about changes in interest rates and how they affect savers and borrowers, but less on what it means for investors. In this article, I take a look at what interest rates are, how they work, and the implications for investors.

What are interest rates?

Interest is the cost of borrowing money and the reward for saving.

Interest rates play a key role in the economy, influencing a variety of financial products including savings, investments, pensions and property markets. When you borrow money, for example for a mortgage, the interest rate is the cost that you pay to the lender to do so – shown as a percentage of the total amount of the loan. Whereas when you put money in a savings account, it earns interest over time increasing the amount in your account. 

Changes in interest rates are often discussed in the news, because of the effect they can have on things like our mortgages and savings. Changes in the interest rates charged by different providers come from changes in policy rates (short-term reference rates set by central banks). 

In the UK, the base rate is the interest rate that the Bank of England charges commercial banks/building societies when they borrow money. It’s reviewed eight times a year and is one of the tools the Bank uses to keep inflation (price increases) in line with its 2% target. 

When inflation is considered too high, the Bank of England may increase the base rate to help slow inflation as it makes borrowing more expensive and saving more rewarding. When inflation is too low, the Bank of England may lower the base rate, which may help push inflation up as it makes saving less appealing and encourages people to spend more. 

If the base rate increases or decreases, commercial banks and building societies usually mirror this and raise or lower their mortgage and savings interest rates.
 

What does a change in interest rates mean for savers?

Interest rates offered by banks and building societies can be either fixed or variable. A fixed-interest rate remains unchanged for a certain period, providing certainty and stability in returns. In other words, you know exactly how much you will get back over the period you save for. However, your money is typically locked in for the whole period, and early withdrawals may not be allowed. 

In contrast, a variable interest rate can change over time, which means your returns may go up or down. However, your money is not locked in, and you can withdraw it at any time.

Saving vs investing

Investing is different from putting your cash in a savings account to earn interest. You’re essentially buying investments, for example, shares in a company, that you think you’ll be able to sell for a higher price later. You can either buy these investments yourself or invest in a fund where the fund manager chooses the investments for you. If you're saving into a pension, it's likely you'll be investing in funds.

What can a change in the interest rate mean for investors?

When you invest, there are a variety of financial assets that you can invest in, such as shares and bonds. Let’s look at how these can be affected by interest rates.

Shares

When investing, shares (sometimes known as equities) represent ‘ownership’ in a company. This means that you are essentially purchasing a piece of the company, which means you receive a share of its earnings and ownership of its assets. 

Over time, shares can offer greater potential for higher returns, but they can also see greater changes in value through volatility, or sharp, sudden changes. It’s why investing in shares is best done over the long term, where any of these changes can often be smoothed over.

The value of company shares depends on several factors including how well the company performs and how profitable it is. 

Changing interest rates can affect the borrowing costs of companies, in other words, how much it costs them to repay any loans they have. If interest rates fall, their cost of borrowing may also fall, meaning higher profits. This could impact their valuation and increase their share prices. 

If you hold those shares, your return (the money you get back) could be higher. On the flip side, higher interest rates may increase a company’s borrowing costs, possibly lowering their profits and potentially the value of their shares, so in that case, holding those shares could lead to lower returns on investment. 

Bonds

Bonds are essentially a form of ‘I owe you’. When you buy a bond, you’re lending money to a company (corporate bonds) or a government (UK government bonds are known as gilts). In return, they promise they’ll pay you back later with interest. You can invest in individual bonds or bond funds, which are collections of many different bonds, with different interest rates and repayment times. 

Interest rates and bond prices have an inverse relationship. When interest rates go up, new bonds pay more money (higher interest), so fixed-interest bonds already in the market that pay less become less attractive. This makes their prices go down. Conversely, when interest rates go down, new bonds pay less money, so existing fixed-interest bonds that pay more become more attractive. This makes their prices go up.

Making investments more resilient

Investing in a broad range of shares and bonds, and possibly other assets such as commercial property is known as diversification and is designed to help to spread risk. It can help protect your investments from volatility, including the effects of changes in interest rates. When you invest, you typically do so for the longer term, which can help smooth out any changes in value over time.