Interest rate rises affect ordinary people because they change the cost of borrowing money and the reward for saving money. When a central bank raises its interest rate, the effects can spread throughout the economy, influencing mortgages, rents, savings, spending, employment, house prices and even government finances.

The impact is not the same for everyone. A person with a large mortgage can be affected very differently from someone with substantial savings. However, for many households, especially those carrying significant debt, higher interest rates reduce the amount of money available for everyday spending.

Mortgages Become More Expensive

One of the most immediate effects of higher interest rates is on people with mortgages.

For example, imagine someone has a $500,000 variable-rate mortgage. If their interest rate rises from 4% to 5%, the amount of interest charged on the outstanding balance increases substantially. The actual monthly repayment depends on the loan term and repayment structure, but the household will generally need to devote more of its income to paying the mortgage.

This leaves less money available for other things such as groceries, restaurants, holidays, entertainment, clothing, cars and savings.

For households that were already spending a large proportion of their income on their mortgage, even a relatively small increase in interest rates can create significant financial pressure.

People with fixed-rate mortgages may not feel the effect immediately. However, when their fixed-rate period ends and the mortgage is refinanced, they may face a substantially higher interest rate than the one they originally locked in.

First-Home Buyers Can Find It Harder to Buy

Higher interest rates can also make it more difficult for people to purchase their first home.

Banks generally assess whether borrowers can afford their mortgage repayments. When interest rates rise, repayments become larger, meaning the amount a person can borrow may fall even if their income has not changed.

Imagine that someone could previously afford repayments associated with a $700,000 mortgage. If interest rates rise significantly, the same income may only support a smaller loan.

This can force potential buyers to save for longer, purchase a cheaper property or delay buying altogether.

There is another side to this, however. Higher interest rates can reduce the amount buyers are willing or able to pay for houses, which can put downward pressure on property prices. Therefore, higher rates can make the mortgage more expensive while potentially reducing the price of the property itself.

Renters Can Be Affected Too

People who rent can also experience the consequences of higher interest rates, although the relationship is less direct.

Many property investors have mortgages. When interest rates rise, their mortgage costs can increase significantly. Depending on the rental market, landlords may attempt to increase rents to offset some of these costs.

However, landlords cannot automatically pass every increase onto tenants. Rent is also determined by factors such as housing supply, demand, vacancy rates, population growth and local economic conditions.

Higher interest rates can also make it harder for some renters to become homeowners, because buying becomes more expensive to finance. This can keep some people in the rental market for longer.

Savings Can Become More Valuable

Higher interest rates are not necessarily bad for everyone.

People with savings can potentially benefit because banks may offer higher interest rates on savings accounts and term deposits.

For example, if someone has $50,000 in savings and the interest rate increases from 2% to 4%, their annual interest income could increase from approximately $1,000 to $2,000 before tax, assuming the entire balance receives those rates.

This is particularly relevant for people who have substantial savings and relatively little debt.

It creates an important distinction between borrowers and savers. Rising rates generally make borrowing more expensive while making interest-bearing savings more rewarding.

People Spend Less

One of the main reasons central banks raise interest rates is to influence spending in the economy.

When mortgages and other loans become more expensive, households have less disposable income. Someone who previously had an extra $1,000 a month after paying their regular expenses might have considerably less available after their mortgage repayment increases.

That person may reduce spending on restaurants, travel, entertainment or large purchases.

Even people without mortgages can become more cautious. If they know borrowing is becoming more expensive and the economy is slowing, they may decide to save rather than spend.

When millions of households and businesses make similar decisions, total spending in the economy can decline.

Businesses Also Face Higher Costs

Interest rate rises affect businesses as well as households.

Businesses frequently borrow money to purchase equipment, build facilities, open new locations or finance day-to-day operations. When interest rates increase, the cost of that borrowing rises.

A business might therefore decide that a planned expansion is no longer worthwhile.

For example, a company considering borrowing $10 million to build a new facility may find that the project generates an acceptable return when borrowing costs are low but becomes much less attractive when interest rates rise.

Businesses may respond by delaying investment, reducing costs or slowing hiring.

This means interest rate rises can eventually affect workers as well as borrowers.

Employment Can Be Affected

Higher interest rates can slow economic activity.

If households spend less and businesses invest less, companies may experience weaker demand for their products and services. Some businesses may respond by reducing hiring or, in more difficult circumstances, reducing their workforce.

This does not mean that every interest rate increase causes unemployment to rise immediately. Employment is affected by many other factors, including population growth, productivity, government spending, exports and conditions in individual industries.

However, reducing economic demand is one of the mechanisms through which higher interest rates can eventually influence the labour market.

House Prices Can Change

Higher interest rates can also affect property prices.

When mortgage rates are low, buyers can generally afford larger loans for a given income. When mortgage rates rise, their borrowing capacity decreases.

If many buyers have less borrowing capacity, competition for houses can weaken.

This can put downward pressure on property prices.

However, house prices are influenced by many other factors, including housing shortages, population growth, construction, migration, incomes and government policies.

Therefore, rising interest rates do not guarantee that house prices will fall.

Lauren Hua is a private client adviser at Fairmont Equities.

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