Thu | Jun 20, 2024

Oran Hall | The personal impact of high interest rates

Published:Sunday | June 9, 2024 | 12:07 AM

Central banks, such as the Bank of Jamaica, find it necessary sometimes to pursue policies that cause interest rates to increase to bring stability to the economy. While high interest rates can be beneficial to people who have funds to invest in...

Central banks, such as the Bank of Jamaica, find it necessary sometimes to pursue policies that cause interest rates to increase to bring stability to the economy.

While high interest rates can be beneficial to people who have funds to invest in interest-earning instruments, and to businesses that have investible funds, they tend not to find favour with borrowers because of the consequent higher cost of servicing the debt.

High interest rates make it more costly to borrow to buy consumer goods, to invest, to operate businesses, to fund education, and to acquire long-term assets such as residential, rental and commercial properties. They also affect the money market, the bond market, the stock market and the foreign exchange market. In a real sense, high interest rates affect all of us.

On the positive side, people who have money to save and to invest in bonds and debentures benefit when interest rates increase because they earn more interest income.

As rates increase, it is advisable to invest in short-term bonds and debentures and then to invest in long-term instruments when the rates peak. This gives them the benefit of continuing to earn interest at the higher rate when interest rates decline. For example, a person who invests $1 million in a 10% fixed-interest rate bond for 10 years continues to earn $100,000 per year for 10 years even if the interest rate on 10-year bonds subsequently falls to, say, eight per cent.

Given the apparent reluctance of deposit-taking institutions in Jamaica to raise the rates on savings instruments, though, savers do not seem to benefit much when interest rates increase in the market.

Investors in equities listed on the stock exchange do not generally benefit when interest rates increase either. One reason is that some investors may switch from equities to interest-bearing instruments. The lower demand for equities often tends to cause stock prices to fall.

Additionally, high interest rates may adversely affect the profits of companies that use short-term funds heavily to fund their business. Long-term funds raised at high interest rates tend to have the same effect. The higher cost of funds inevitably causes the cost of doing business to increase and may affect the profits of the listed company negatively, thus causing the price of its stock to decline on the stock market.

Even unit trust and mutual fund prices can be negatively affected by higher interest rates. Higher interest rates cause the price of fixed-income bonds and debentures to fall, thus affecting bond funds negatively. Funds that invest in equities tend to also experience declines in their unit value or share value when high interest rates cause the price of equities to fall, as we bear in mind that valuations are done regularly to reflect current prices.

The long view

Higher interest rates effectively reduce the disposable income of consumers who choose to borrow because of the higher interest they pay on their loans. Prudent spenders respond to such a situation by reducing consumption. The less prudent approach is to maintain the same level of spending by saving less or borrowing, neither of which is the best for long-term financial well-being.

Increases in interest rates do not affect consumers whose loans pre-date the increase in interest rates if the loans are fixed-rate. This is not so for variable-rate loans as their cost increases as rates increase generally in the economy. Borrowers should, therefore, be careful to know what they are committing to. Know if the loan is fixed-rate or variable-rate. Careful note should be made of mortgages in this regard. Not being able to make such payments in full or on time can be disastrous.

Higher mortgage rates can upset the plans of some people to own their own homes because of the change they can make to the ability of the prospective borrower to afford the loan. Similarly, they can upend the plans of individuals who must depend on borrowed funds to acquire advanced education in the hope of bettering their lives.

Governments, through their central banks, typically see higher interest rates as justifiable to control inflation and protect the value of the local currency. One reason for inflation – a sustained increase in the general level of prices – is demand for goods and services being higher than supply. As a policy option, the intention is that higher interest rates will make it more costly to borrow, thus dampening the demand for goods and services, ultimately causing prices to fall or increase at a slower pace.

Another consideration is that people with funds to invest will tend to seek the best rates and may invest in securities issued in other countries or their currencies. By increasing interest rates in the local economy, the central bank expects to discourage the movement of money into securities denominated in foreign currencies so that the demand for foreign currencies can be checked.

Failure to arrest the demand for foreign currency tends to cause the price of the local currency to fall, leading to the cost of imports increasing and the inflation rate rising.

High interest rates are not meant to continue endlessly. They are expected to decline in a controlled way as the economic situation of the country stabilises. To avoid being in a disadvantageous position, it is important to keep informed about what is happening in the economy and to get good advice.

Oran A. Hall, author of Understanding Investments and principal author of The Handbook of Personal Financial Planning, offers personal financial planning advice and