How Do Interest Rates Affect Stock Prices?

by Valencia Higuera

Individuals who invest in the stock market are typically looking to get the highest return on their money over an extended period. Stock prices frequently fluctuate, and various factors influence the value of a particular stock. There is an indirect connection between stock prices and interest rates. As interest rates shift, stock values can become unstable.

Definition of Interest Rate

Banks and financial institutions borrow money from the Federal Reserve, and then lend these funds to consumers. The Fed charges banks an interest rate on borrowed funds the same way a bank charges interest on consumer loans. Interest refers to the fee or price for borrowing money from a bank. Interest applies to every type of loan from mortgages to student loans. Interest rates also determine how much a person can borrow because a low interest rate can prompt a more affordable payment.

Interest Rates and Businessses

It is more expensive for banks and other lending institutions to borrow money when the Fed increases the interest rate. Banks can respond in one of two ways. They can tighten their lending guidelines and create fewer loans, or banks can increase the interest rate charged on consumer loans to compensate for their higher interest rate. Consumers can obtain loans when rates increase, but they'll pay more for mortgages, auto loans and credit cards.

Consumer Spending and Rates

Although consumers continue to apply for loans when interest rates increase, higher rates have a ripple effect that can eventually impact stock prices. For example, a consumer might purchase a home and accept a higher mortgage rate. This mortgage rate can greatly increase his home loan payment, which reduces his disposable income. The same holds true for credit card rates and auto loan rates. If a credit card or auto loan company increases a consumer's rate, the consumer may spend less or delay a vehicle purchase to avoid an excessive rate and higher payments.

Stock Prices

If the Federal Reserve continues to increase interest rates, and if consumers cut back on spending, these actions ultimately affect stock prices. A company's stock price can only increase if there's a demand for a product or service, and if consumer's spend money with the company. Stock prices are based on growth potential and profits. Because consumers tend to spend less when interest rates increase, this impacts a company's bottom line. The less consumer's spend with a company, the lower a company's stock value.

About the Author

Valencia Higuera is a freelance writer from Chesapeake, Virginia. She has contributed content to print publications and online publications such as Sidestep.com, AOL Travel, Work.com and ABC Loan Guide. Higuera primarily works as a personal finance, travel and medical writer. She holds a Bachelor of Arts degree in English/journalism from Old Dominion University.

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