How Does the Change in Interest Rate Affect Individuals & Businesses?

The interest rate an individual or a business pays on a loan depends in large part on the credit rating of that person or organization. However, the rates offered by lenders, in aggregate, are shaped in large part by larger economic forces that affect the supply and demand of money. A change in the average rate of interest typically affects businesses and individuals in a number of ways.

Economic Changes

The interest rate has a direct effect on the economy. Typically, lower interest rates encourage businesses to expand. This is because businesses are able to borrow money at a lower price. This provides an incentive to borrow the money necessary to enlarge the business. This also can translate into the hiring of more employees, which can further stimulate the economy. However, interest rates that are too low can cause the economy to overheat and drop.

Consumer Spending

Changes in the interest rates push consumer spending up and down in two ways. First, when a shift in the interest rate expands or contracts the economy, the employment rate shifts. For example, when more people have jobs, as is the case during an expansion, individuals typically spend more money. Second, when interest rates are lower, people spend more money, because they can borrow money more cheaply. When interest rates are higher, people spend less.

Business Loans

Businesses may consider expanding when interest rates are low, because they can secure business loans at a lower rate of interest. For a business, a period of low interest rates may signal a time in which the business should choose to move into another market, gain a large client base or launch a new product. However, low interest rates do not always mean loans are easier to obtain, only that they are, on the whole, cheaper.

Mortgages

One particular type of consumer spending is directly tied to the interest rate: home buying. Because most people have to take out a loan to purchase a home, when interest rates rise, fewer people buy homes, because it costs them more money to do so. Conversely, when interest rates drop, more people are likely to buy homes, as the price of the loan has been reduced. Therefore, the interest rate can directly affect the percentage of people who rent rather than buy a residence.