As a novice in the financial world, the interest rate is one of the many unknown or unclear terms that you will encounter in your journey. Financial experts love to talk about it and mention it in conversations, especially in times like these when inflation rises and poses a significant threat to the finances of everyone in the world.
With that said, most people aren’t aware of the real interest rate, the nominal interest rate, how they are related to inflation, and how all of those things affect market returns. That is why we’ve decided to dedicate an article to this particular subject so that when your friends, colleagues, or even your financial advisor discusses these matters with you, you already have the needed knowledge to be able to participate in the conversation.
Now, without further ado, let’s dive into the topic.
The Interest Rate – Real, Nominal, and How It’s Calculated
It would be impossible to explore the topic at hand without first giving definitions to some of the key terms such as interest rate, real interest rate, and normal interest rate.
First, let’s start by explaining what financial experts mean when they talk about the interest rate. Whenever you take out a loan, the percentage of money that the bank (loaner) charges you based on the amount they gave you is called an interest rate. For example, if you took out a loan for $100 with a 5% interest rate, you would have to pay back $105 to the bank at the end.
Okay, now that this first term is precise, let’s move on to the second one. When talking about nominal interest rates, we generally discuss the interest rates before they get adjusted according to the current inflation. This term can also mean the stated interest rate on the loan before the additional fees get considered.
And finally, the real interest rate is the interest rate that has been adjusted so that the effects of inflation are negated. Once that’s done, the interest rate will show the “real” cost of the funds that the bank or loaner gave to a particular investor or loaner.
The idea behind the interest rate is to reflect how prices of current goods will increase in the future. That’s why, when investments are made, the real investment rate is calculated in the following manner:
- Real interest rate = nominal interest rate – the inflation rate (it can be an expected or current rate).
Inflation and the Purchasing Power of Money
Now that you know more about the interest rate, you might be wondering why inflation matters so much to this equation. Inflation measures how much the prices of goods rise over a period of time, which also showcases the decline of the purchasing power of a given currency.
For example, suppose you could buy one bread and one bottle of water for $1 a year ago, and now you’re looking at a cost of $1.50. In that case, that’s a clear indication that the purchasing power of that one dollar has decreased, which means that in that one-year period, the inflation rate increased.
However, when we discuss deflation, the prices of goods start to decrease, so the currency’s purchasing power increases. Taking the example from above, deflation would be if that same $1 price from a year ago would today buy you bread, water, and an apple.
Why Does the Real Interest Rate Matter?
Now that you know all about interest rates, as well as inflation and purchasing power, you might be wondering what’s the value of knowing the real interest rate. As you already know, the nominal interest rate is the one that you’re actually paying on a given loan. However, the idea behind the real interest rate is to show how the purchasing power of the money given by the borrower changes over a particular period of time.
Typically, banks show the nominal interest rate when they’re trying to promote their products, and it’s something that helps, especially if you know that inflation will be increasing. The money you take on credit will start to lose its purchasing power.
According to one theory called the time-preference theory of interest, the real interest rate can be used to showcase whether the person who takes out a loan prefers future or current goods. People who are willing to pay a higher interest rate for loans are usually the ones who prefer to use funds for current goods over future ones. On the other hand, a lender willing not to use a product right now might also loan money at a lower rate. Overall, for people who work in the financial sector, the real interest rate can reveal the time preference amongst people who are looking to take out loans.
How the Rising Interest Rate Affects the Stock Market
When the interest rates rise, it becomes more expensive for businesses to raise their capital because they have to pay more for the bonds they issue. This practice of making capital raising more costly can lead to fewer growth prospects in the future and will immediately lead to a downward spiral when it comes to profit expectations. That’s why if a company becomes less profitable or starts to cut down on growth, the price of that same company’s stock will also decrease.
Following this same logic, if many companies start to slow down on their growth and, as a result, their stock prices decrease, the entire market, along with the most well-known indexes like the S&P500 and the Dow Jones, will also go down. This process will make investors more unwilling to put their money into stocks, make their previous ownership of stocks less profitable, and make the purchasing of stocks a more risky decision compared with other investments.
That said, some sectors tend to benefit from the high-interest rates. That’s especially valid for the financial sector, including banks, mortgage, and insurance companies, whose earnings often increase during such periods as they’re able to charge more for lending money.
How the Real Interest Rate Affects Market Returns
As you already know, the real interest rate is a combination of the nominal and current inflation rates. This means that when it comes to investments, the inflation rate will decrease the value of an investment return as it actively decreases the rate of return.
If this sounds too complicated, let’s take a look at an example. Let’s say the rate of return for stocks you hold is 6%, and the inflation rate is 3%. This would mean that the actual or “real” return is 3%, not 6%. What happens when you adjust the interest rate of 6% to the current inflation of 3%, and so you get a lesser “value” from your investment by 3%.
All of this means is that when inflation rates rise or when they’re expected to do so, stocks become a more risky investment that might go wrong if the decisions taken by the investors aren’t well-researched and thorough.
In Conclusion
Hopefully, this article gave you enough information about interest rates and how they affect the stock market so that next time your financial advisor or your colleagues are discussing a similar topic, you will be able to be an insightful participant. If you’re looking to start investing your money and you’re unsure about how to go about it, we at Alpha Wealth Funds will be more than happy to help with financial advice from our experts, who have years of experience in the stock market.
With that said, it’s still good to remember that if you have decided to start investing your savings and you’re new to the world of finance, finding useful resources and learning more is vital, even if you choose to hire someone to help you with making the right decisions. At the end of the day, it will always be better if you understand how the markets operate and you have an idea of how your money is being invested.
Please feel free to reach out to me on this or any of your investment needs or questions. I may not always have the answers at my fingertips, but I promise I will get them for you. Harvey Sax
Founded in 2010, our services include boutique hedge funds, separately managed accounts, financial planning, estate & trust services, private placements, and in-house concierge services for high net worth individuals, families, and businesses.
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