What are interest rates?

June 16, 2023  |  Scalable Capital
Asset Blog Interest i18n 1920
Interest rates can influence our investment decisions, so it is important to understand what they are and how they work.

In general, we could define the interest rate as the "price of money". Broadly speaking, it is the rate that banks charge on the money they lend to us, a transaction from which they make a profit. On the other hand, the interest rate also determines the percentage of remuneration that financial services or investment institutions give us in exchange for depositing our savings in an account.

How interest rates work

The official interest rate, which serves as a reference for the rest, is set by the monetary authority of a country (such as the US Federal Reserve) or a union of countries with a common monetary policy (such as the European Union). In the case of Spain, the entity in charge of defining the official interest rate is the European Central Bank (ECB). This institution conducts the common monetary policy of the euro and can raise or lower interest rates depending on the economic situation.

Without going into too much detail, the interest rate is a tap that central banks can open or close to control the flow of money in circulation and ensure economic stability.

Why interest rates rise

Inflation has a lot to do with the rise in interest rates, although there are other factors, such as the demand for credit. As prices rise across the board, purchasing power suffers and, to compensate, central banks such as the ECB may decide to raise interest rates. In this way, as well as containing inflation, they ensure that the common currency, in this case the euro, does not lose value and the economy remains stable.

When inflation is very high, raising interest rates can help to bring inflation down to the 2 % target in the medium term.
As regards the demand for credit, higher interest rates can respond to the law of supply and demand. The higher the demand for credit, the higher the interest rates at which banks lend money. And vice versa: if the demand for credit falls, there is a greater supply of credit available, making money "cheaper".

Consequences of higher interest rates

Rising interest rates can improve the rentability of deposits, i.e. the money we deposit in an interest-bearing current account and which earns interest in our favour. In this sense, this is good news for savers. However, this does not mean that savings will maintain their purchasing power in the long term, as the returns on an interest-bearing account do not outpace inflation in the medium and long term. Moreover, as we have already mentioned, central banks raise or lower interest rates depending on the economic situation. For their part, commercial banks and other institutions adapt their offerings based on official indicators, so it is foreseeable that deposit conditions will change over the years.

How can we benefit from rising interest rates?

In general, fixed-income products become more attractive when interest rates rise, as the yield they offer is higher in these periods, as is the case with bonds and interest-bearing accounts.

However, the effect of rising interest rates is temporary, so although the easy answer might be to deposit all our savings in a high-yield account or buy Treasury bills, the reality is that if we want to beat inflation in the medium and long term, we need to diversify our investments by allocating part of our savings to equity products such as company shares or ETFs, exchange-traded funds that track a stock market index. Investment plans that include broadly diversified ETFs can be a good way to get started in the world of capital markets.

At Scalable Capital's broker we have combined the benefits of an interest-bearing account with access to fixed income and equity products such as bonds, stocks and ETFs.

Risk Disclaimer – There are risks associated with investing. The value of your investment may fall or rise. Losses of the capital invested may occur. Past performance, simulations or forecasts are not a reliable indicator of future performance. We do not provide investment, legal and/or tax advice. Should this website contain information on the capital market, financial instruments and/or other topics relevant to investment, this information is intended solely as a general explanation of the investment services provided by companies in our group. Please also read our risk information and terms of use.

Author Scalable Capital
Scalable Capital
Broker with flat rate
Scalable Capital is a leading fintech in Europe that brings people and technology-based investing together. Scalable Capital offers a broker with a trading flat rate that enables customers to trade shares, ETFs, cryptocurrencies and funds themselves and to conclude savings plans.