Relationship Between Interest Rate & Investment

by Linda Ray

Interest rates drive the economic engine that affects business and consumers locally, nationally and globally. Financial managers, investors and consumers constantly weigh the pros and cons of spending and borrowing in the light of current interest rates. Just as interest rates play a decisive role in your borrowing decisions, they also influence your portfolio management decisions.

Banking Role

Banks are the intermediaries between depositors and borrowers. Consumers and investors deposit their savings into banks in return for a small amount of interest on the money as well as access to a range of services, such as automated tellers and checking accounts. Borrowers, both businesses and consumers, turn to banks for loans to make investments in their homes, grow their companies and complete their college educations. Those loans are made at a considerably higher interest rate than the depositors received. The difference between what the banks provide depositors and what they charge borrowers is the profit by which they grow.

Effects

Banks benefit most of all when interest rates create attractive borrowing terms and lending remains brisk. The amount of interest that banks can collect from borrowers directly impacts the number of loans they'll be able to make in the future. The more loans a bank can provide because of its increase in deposits and profits gained from higher interest rates, the more investment you can expect to see nationwide.

Mixed Messages

The most obvious relationship between interest rate and investment is the reduction in borrowing that businesses and consumers make when interest rates are high. Business tends to decrease capital investments when they must pay higher interest rates on loans. Consumers cut back on spending when high rates drive up the costs of goods. At the same time, according to the Review of Economic Studies, by delaying investments, businesses decrease their rate of growth and end up paying higher interest rates on their outstanding debts. Consumer confidence rattles economic growth when spending decreases radically, producing even greater market volatility.

Worthiness

The amount of interest that you are charged for borrowing money depends on a number of variables. Your creditworthiness, which is a result of your history of using credit determines the rate of interest you receive on a loan. The lower your interest rate, the more likely you are to invest in a new home, car or business expansion. The United States government, the country's largest borrower, has the most effect on the U.S. economy. Interest rates move up and down in accordance with the current rate paid on the bonds the government sells to fund its operations. The ultimate relationship between investments and interest rates always comes down to the treasury benchmark, often referred to as the interest rate.

About the Author

Linda Ray is an award-winning journalist with more than 20 years reporting experience. She's covered business for newspapers and magazines, including the "Greenville News," "Success Magazine" and "American City Business Journals." Ray holds a journalism degree and teaches writing, career development and an FDIC course called "Money Smart."