What Happens If Interest Rates Rise?

As with most things in the economy, a single factor change affects different people and institutions in different ways. The ones most commonly discussed are:

  1. How it affects individuals
  2. How it affects the government
  3. How it affects banks
  4. How it affects the stock market

There are many other sectors and specific players as well. For example if rates go up how would it affect car dealers? Higher lease prices will not increase shares. You might want to think through your own situation in some detail.

Individuals

There are two groups. Those who owe money and those who invest money.

Those who invest in dollar denominated investments like bonds, term deposits, and maybe mortgages will enjoy the higher rates, except if the rate has been driven up by inflation and the requirement for a real rate of return. The problem is the income taxes. An investor who uses the income to support life style would prefer 3% in a 0% inflation world to 8% in a 4%.  inflation world. While the spread looks the same, for a 40% marginal rate taxpayer $5 returns 2.6% after taxes while 8% yields only 0.8%

If you are an investor for spending money, be especially careful of your tax planning as rates rise along with inflation.

Those who borrow.

This one is harder. It depends on whether you can afford the cash flow requirement. If rates rise as inflation pushes them up,  you both win and lose. The principal becomes worth less in purchasing power. So a win. That works if you have a fixed rate. Today though, many mortgages are for shorter term or even floating rate. If a 2% floating rate mortgage becomes 8% the payments may well increase by more than your ability to pay them. That is a bad thing.

What to do? There is a fair bit of arithmetic to work out. If you lock in 4% now for five years, you will be paying more now and less later if rates go up to 8%. There is a breakeven point somewhere in the lock in period. Realistically the whole thing is a risky guess. In some circumstances, you might be able to make the mortgage interest deductible against investment income. Check that out.

The huge risk in owing a mortgage is the house price will fall as rates rise. Why? Because people don’t buy houses exactly, they acquire a mortgage they can afford, given their down payment. If the house is worth $500,000 when you have a hundred thousand down and a mortgage at 2% amortized over 25 years,  your monthly payment is about $1,700. I the rate became 6%, then the payment is about $2,550. In that rate world, the mortgage you can get for $1,700 a month is about $270,000. So the house must cost just $370,000. People who cannot afford the rate change may not be able to get out either.

The governments.

Governments owe more money than we can imagine. In Canada ar march 31, 2020 total government debt was $2.434 Trillion. If we assume it is now over $2.5 trillion, we might be wrong but at that level details don’t matter. In the U.S. about $32 trillion. In the United States the 10-year bond rate projected for 2022 is 1.4%, so interest cost will be work out to be about $448 billion. In Canada the bill will be about $50 billion so around 2%,

If inflation is 2% or so, theys tand to reduce the value of the principal by the amount of interest paid. So in theory no cost. But if interest rates became 5%, the cash cost in the US would be about 4x higher than they pay now. About 1.6 Trillion dollars a year. Or 4.5 billion per day. That will certainly minimize other program payments unless the economy grows faster than rates. Not even a little likely.

Just like house owners, the cash costs will harm other spending.

The banks

Banks do better when rates are higher. If you are lending mortgage money at 2%, it is hard to get the margin you need to pay overhead and and interest to depositors. At a 6% lending rate, it is much easier.

If the banks can lend in a reasonable volume, higher rates will be positive. The demand for money may fall though. Be cautious.

The stock market

Ben Carlson did an article on this. You can and should look at it. Do Interest Rates Matter More to the Economy or the Stock Market?

As you will notice higher rates don’t harm the stock market much, Over the intermediate to long term. You will need to be quite disciplined to get that to work for you if it even happens again. If rates rise sharply the stock market will be affected because for a decade the carry cost to own stock has been near zero. Many people will close their positions when the cost rises. There should be a significant drop overall then. It would recover over the next few years no doubt.

An approach. Increase your cash balances and look for bargains. The old horse breeders maxim applies. Keep the best and sell the rest.

The takeaway

The economy is hideously complicated. It all fits together in inscrutable ways. Interest rates are the price of using someone else’s money. prices are always difficult to assess, whether antiques or the reasonable price of a vacation. Prices are different for different people.

Higher interest will affect the economy in general, but it will affect individual components of it in different ways. Understand your place and assess how you personally would be affected.

How much higher they may come to be will matter.

Maybe they won’t go up at all. That will have effects too. Assess that possibility of no change.

Other economies may be different. Consider diversifying by currency.


I help people have more retirement income and larger, more liquid estates.

Call in Canada 705-927-4770, or email don@moneyfyi.com

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.

%d bloggers like this: