How do Interest Rates Impact the Stock Market?

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How do the interest rates affect the stock market?
When you listen to financial news or read about the markets you frequently hear questions such as, “When is the Fed raising interest rates?”
At its core, interest rate is simply the cost of using someone else’s money. The interest rate that the investors mostly refer to is the rate at which the Federal Open Market Committee sets for the Federal Funds, and at which banks borrow from and lend money to each other.
This borrowing and lending activity affects the entire economy, including the stock market. Interestingly, the interest rate change takes about a year to affect the widespread economy, but the investors and markets react instantly.
As an investor it is crucial to understand the relationship between the interest rates and the stock market. The Fed changes interest rate to control inflation. Simply put, the Fed increases the rate to decrease money supply. When the interest rates go up it is more expensive to obtain money. The opposite is true as well, when the interest rates go down it makes borrowing money much easier, which leads to more spending.




The United States has the Federal Reserve, other countries have central banks that do the same. This interest rate is also important because, the prime rate is more or less the same, which is the rate at which the most creditworthy customers borrow money from commercial banks. The prime rate is what determines the mortgage rates, your credit cards’ annual percentage rate (APR), and other business and consumer loans.

Let’s look at what happens to the economic and investing activity when the interest rates rise…

From the discussion so far there has been no mentioning of interest rate changes directly impacting the stock market. So how does the rate at which banks borrow money from each other affect stock prices?

When the interest rates increase, the prime rates also increase, which increases the credit card rates and the mortgage rates. Since the average consumer has to pay more for these items, they are left with less disposable income. In other words, the consumer has less money to spend on low priority important items.



If a hotel chain depends on people to spend on vacation packages, its profits will drop because people having less disposable income. Similarly, households will be more reserved in their spending, which could look like cutting down on restaurant bills and cheaper brands for grocery shopping.

But businesses are affected in a more direct way as well. Businesses borrow money from banks to expand their operations. When it becomes more costly to borrow money, they curb or revise their expansion plans. As they cut down on expansion it slows the growth. Depending on the business model it might even trigger cutbacks.
When these factors reduce the net income of a listed company, its stock price usually drops. And this is how the change in interest rate impacts the stock market.