THE IMPORTANCE OF INTEREST RATES FOR INVESTORS
Learn even more about this topic with the Encyclopedia of Personal Finance™

Do you have bonds or Treasury bills? A car loan or a mortgage? What about stocks or mutual funds? All of these financial instruments are affected by interest rates.

If you invest in bonds or Treasury bills, you are essentially lending money. In return, you hope not only to get your original investment back, but also to earn interest payments (yields) that compensate you for lending. Obviously, you earn more money if you receive a higher interest rate. Your rate of return on the investment is determined by the rate of interest that you receive.

If you wish to borrow in order to buy a car or a house, you want the lowest possible interest rate. Often borrowers will try to refinance their loans when interest rates fall. Whether you are borrowing or lending money, interest rates have a fundamental impact on your decisions.

Even the performance of stocks is affected by interest rates. A stock's price is determined primarily by earnings and future growth opportunities. Companies often finance new growth opportunities by borrowing. If interest rates rise, borrowing becomes more expensive and fewer investments are undertaken. This may lead to slower growth in earnings, which would have a negative impact on the company's stock price.

Furthermore, investor demand for stock in general is affected by interest rates on bonds, which are often assumed to be "safer" investments. When bond rates are high, investors tend to choose bonds over their more volatile cousins, stocks, and vice versa. However, bonds are subject to credit, interest rate, and inflation risks and can lose principal value when interest rates rise.

As you can see, interest rates have a fundamental impact on nearly all investment decisions. The rate of interest is one of the cornerstones of the economy. But what determines interest rates? Let's take a look at one important factor now -- inflation.