Effects of Higher Interest Rates

When interest rates rise, consumers, businesses and the economy are affected in several ways. Rising interest rates affect the spending habits of consumers, businesses and the overall health of the economy. When it comes to interest rates, there has to be a fine balance to make sure the economy functions smoothly.

Consumer Spending

When interest rates increase, consumers are less likely to purchase products such as automobiles, mortgages and other consumer goods. Higher interest rates means consumers must pay higher finance charges. Two-thirds of economic activity is based on consumer spending and when consumers stop spending the economy slows.

Recession

If the economy goes into a recession, businesses lay off workers because of the lack of demand for goods and services. To spur demand, businesses will sometimes lower prices. Consumers will delay spending because they will wait to see how low the prices will go. Companies and organizations will lay off more workers because they will try to cut expenses in an effort to maintain profit margins.

Deflation

An economy can enter a state of deflation, which is a constant downward spiral of prices. As more consumers delay spending while waiting for prices to bottom out, the economy slows even more. There will be more layoffs and more price reductions.

Cost of Funds

Many companies need to borrow money and accumulate hefty debt loads if they want to continue to do business. When interest rates increase, the cost of borrowing money increases as well, which cuts into the profits of a company. A decrease in profits will cause the price of a company's stock to decrease.

Payment Increase

A lot of consumers have credit products such as credit cards and mortgage loans that have variable rates. When interest rates increase, a consumer's monthly payments will increase as well in order to accommodate the higher amount of interest that needs to be paid monthly. If the payments on a mortgage increase substantially, many consumers will not be able to make the payments, leading to delinquency and foreclosure.

Bad Debts

If consumers cannot make credit card payments, credit card companies will probably have to write off a number of accounts as bad debts. In order to stop the losses, many credit card issuers will lower consumer credit card limits as well as the limits on home equity accounts. This will further curtail consumer's ability to spend and throw the economy further into a downward spiral.