Using super simple language. With all the dumb questions you were too scared to ask.
The short answer: rising interest rates means that the cost of taking on debt increases.
When you take out a loan, a line of credit, or a mortgage you are borrowing money with the promise to pay it back plus some amount of interest. That interest is the reward that the lender gets for giving you their money for a period of time. There is a risk that you won’t pay them back on time or in full. The lender is unable to do anything else with that money while you are borrowing it, like investing it. There is a value to the time while you have their money. That is why interest exists. If the rate of interest were 0%, there would be no reason why anyone should lend you their money.
First we need to talk about central banks. What are they? What do they do?
Central banks (like the Federal Reserve in the US, the Bank of Canada, etc) are financial institutions - but they don’t compete with the normal “commercial” banks you use to keep your money safe. Instead, a central bank is given the unique ability to make and distribute money for that currency. Usually each country (or group of countries that share a single currency, like the European Union with the Euro) has only one central bank.
Central banks are supposed to be politically independent, and not controlled by the party in power at any time so that monetary policy can stay stable over the long term. The central bank has the privilege of being the only bank that can issue new cash into circulation. They don’t provide savings accounts, issue credit cards, or give small business loans like commercial banks.
A central bank’s main purpose is to control the money supply and keep inflation in check.
Ok so what? Why the big background on central banks?
Central banks affect a currency’s monetary policy by using the most powerful tool they have - changing the target short-term interest rates between commercial banks. This goes by a few names depending on where you are but is sometimes called the overnight rate, policy interest rate, the federal funds rate, or the interbank offered rate.
Every day, different banks move money back and forth for their customers. If you use your debit card or send money, there is a flow of funds. At the end of each day, the banks need to settle these payments. To balance things out, banks borrow money from each other for one day overnight. Central banks set a target for the interest rate they want commercial banks to charge each other for those overnight loans.
Those commercial banks then lend money out to everyday people and businesses, making their own spread by lending at slightly higher rates than the baseline overnight rates.
Money has supply and demand like anything else. Changing the overnight interest rate for a country either increases or decreases spending and borrowing out in the economy. How? People are much more likely to borrow money when it costs them under 3% than they are at 5%+. That is the difference of an extra $1000 cost every month on a million dollar mortgage. Not nothing.
You might have noticed things cost way more… everywhere than last year. That is called inflation and it is the reduced buying power you have with the same amount of money. Well you’re not the only one that has noticed that things have become a little crazy.
Higher central bank overnight rates makes commercial banks increase their own interest rates on deposits, loans, and mortgages. This encourages saving and discourages borrowing which means less money is spent throughout the economy as a whole. As a result, companies increase their prices more slowly or even lower them to encourage people to buy stuff (aka. demand). This reduces inflation.
Central banks all over the world are now moving very quickly to raise interest rates significantly in 2022.
Central banks are raising interest rates to prevent hyperinflation from wiping out people's life savings - they are starting to pull the emergency brake. Why is hyperinflation a problem? Here’s a real example: after World War 2, the rebuilding German central bank caused a massive devaluation in their currency by printing a huge amount of money to repay their debts. Imagine that all the money you’ve worked your entire life for was suddenly worthless overnight. You would probably question all of the assumptions you’ve made about the value of hard work and stop buying into the idea that the economy works properly. This destroys the fabric of our society and leads to people getting very upset and sometimes violent. So central banks need to act quickly and decisively to prevent us from getting to those kinds of scenarios.
For the past few years interest rates have been very low, hovering just above 0% which has meant that the cost of borrowing was almost nonexistent. In March 2020, many countries’ central banks dropped interest rates to 0.25-0.75% from 2-3% in order to fight the potential economic damage from the pandemic. This, in addition to massively increasing the supply of money, has led to huge speculation in almost all asset classes, including stocks, real estate, crypto, and more. Some people call it a bubble.
In the case of the housing market, rising interest rates will hurt those who have become over leveraged (taken on too much debt). Most people decide how much house they can afford by the monthly payments they can make. With higher interest rates, people can afford a lower amount because they are paying more in interest. It should result in less demand for debt, like mortgages on houses. It could cause the wild offers over asking to stop and return to more normal buying conditions like having conditions on purchases.
Multiple home owners who have used equity in their first house to buy more houses will start to feel the squeeze. The value of the house they took out a home equity line of credit on might end up being less than what it was appraised at when they refinanced. This is a scary scenario. Leverage (aka. debt) works as powerfully when asset values go down as when they go up. If the market suddenly took a dive, your original investment could be gone quickly or you could even still be on the hook for money you no longer have.
Also - home equity lines of credit are usually debt that can be called in at any time by the lender, meaning that the borrower might have to sell their house in a down market to cover the call. That's a potential double whammy.
A lot of these factors reinforce each other in cycles. If everyone is feeling the squeeze on their wallets, more people will sell their houses. If more houses hit the market, supply goes up and prices go down. But everyone is feeling squeezed and so less people are buying, so there’s less demand. Because of all this, people could be expecting houses to go down in price and may choose not to buy which reinforces the downward pressure even more.
Rising interest rates means that the tide is going out and you can see who was swimming naked. Those taking on debt aggressively who can’t handle higher debt repayments could be in for some financial damage.
A high interest environment benefits savers more than spenders since their savings are less hit by inflation and since the returns on lending (HISAs/GICs/bonds) gets higher. At the same time, this can be hard to hear since we are still now in an inflationary environment and sitting in cash is a bad deal for the most part.
The market is fairly efficient, meaning that all of the effects and trends we’ve talked about are already priced into future loan rates. So you won’t get any benefit from going to a mortgage broker now to secure a “low” interest rate before the actual rate hikes happen.
We need to mention that the economy is not decided by interest rates alone. There’s a ton more factors like current global conflicts, prices of commodities, supply chain disruptions, and the spending policies of governments that have their own effects.
It may cause a correction in prices of stocks, real estate, crypto and anything else that is overvalued because of the wild spending and uncontrolled economic stimulus of the last couple years. But that isn’t a reason to sit on the sidelines or try to time the market.
It's a volatile time for sure. A very risky move at this point would be to get super in debt at rates that could be variable and increase beyond a point where you can afford the payments. Above all else, make sure that if you have debt, an increase of several percent in the interest rates will be something that you can handle. If not, now is the time to deleverage (get rid of your debt). Saving your spare money is not a bad idea either as rates rise - you can take advantage of higher returns on savings accounts, bonds, GICs, etc.
Lower interest rates increase spending because people feel like they can afford more stuff. This increases overall demand for that stuff, which drives prices up. It also discourages saving because it is hard to get a good return on your savings.
On the flip side, higher interest rates encourage more saving instead of borrowing. Less borrowing means less spending. The overall effect is that people buy less stuff. This lowers prices if the supply stays the same.