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Level 2 Business and Economics: External Influences

Other Effects of Changes in Interest Rates

Business might be directly affected by a change in interest rates in the way outlined in the previous pages. However, there is another way that they can be affected: interest rate changes also affect individuals - and individuals are customers!

If interest rates change, the incentive for individuals to take out loans to buy goods will also change. If the rate of interest falls, for example, then the charges on a loan to buy larger items like cars, furniture, electrical equipment and so on is also likely to fall. As a result, more people might be willing to buy such items. Businesses selling these items might see an unexpected rise in demand for their products.

A large plasma screen TV

Expensive products are often bought by customers taking out a loan with the supplier. These loans are also subject to interest payments, and so are affected by changes in interest rates. Copyright: Leo Cinezi, from stock.xchng.

Equally, if interest rates rise, people might be put off buying that plasma screen TV that they were looking at, since it is now more expensive to pay back the loan. Businesses selling these items might see an unexpected fall in the demand for their products.

Task 3:

Look at the list of businesses below. Which of these do you think will be most affected by a rise in interest rates and why?

  • Tesco
    Tesco store Copyright: Biz/ed team.
  • Coca Cola
    Someone holding a Coke bottle up against a blue sky Copyright: Dragan Sasic, from stock.xchng.
  • McDonalds
    The McDonalds arches Copyright: Alex Ling, from stock.xchng.
  • Dixons
    Dial on a washing machine Copyright: Josep Lluis Caldentey, from stock.xchng.
  • A car dealership selling BMW cars
    BMW car Copyright: Travis Ryan, from stock.xchng.

Different businesses will be affected in different ways as a result of a change in interest rates. It all depends...

We can see further effects of changes in interest rates by looking at how changing interest rates affect mortgages. Mortgages are loans given to buy property. Over three-quarters of the UK's home owners have a mortgage. For many home owners, the mortgage payment is the biggest single monthly outgoing and houses are not paid off quickly either!

Example:

A typical mortgage might be over a period of 25 years. The average price of a house in the UK is nearly £200,000. If we assume that a home buyer borrows £200,000 over 25 years, the monthly payment will be around £666 - not including the interest. If we assume interest rates are around 6%, then the interest on a £200,000 mortgage would be £300,000 over the 25 years. When we add the principal (£200,000) to the interest to be paid, the total sum comes to £500,000, which amounts to £1,666 each month.


Old whitewashed farmhouse reflected in the pond outside its front door

Housing - the most expensive single financial commitment most people will ever make and one which is heavily dependent on interest rates. If rates change, they have an effect on how much money people have to spend on other things. That affects businesses of all types! Copyright: Beverley Bridge, from stock.xchng.

A quarter of a percentage rise in the mortgage rate would add around £42 per month to the mortgage payment in the example above. For many home owners therefore, the interest rate is important as it affects how much money they have to pay for the loan on their home and therefore what they have left over to buy other things like food, clothing, entertainment and so on.

If interest rates rise, we might expect some householders to cut back their spending on other goods and services. The businesses that are affected by this change in spending behaviour will face changes to the demand for their products and services that they might not have anticipated. Just how badly they might be affected depends to a large extent on how far interest rates rise - not just in one month but over a period of time.

Task 4:

In July 2003, the interest rate was 3.5%. Over the next year, interest rates were gradually increased and by August 2004, had risen to 4.75%.

  • Using the example above, calculate the difference in the mortgage payment per month.
  • What types of businesses are likely to be affected the most by possible reductions by householders in their spending? Explain your answer.

In summary, if interest rates change, mortgage rates may also change. When mortgage rates change, households notice a change to their monthly outgoings and may adjust their spending on other things as a result. Businesses, therefore, are affected directly by changes to their loan costs but also by possible changes to the demand for the products and services they sell.

Task 5

We have mentioned that different businesses will be affected in different ways by the changes to interest rates. An important skill in Level 2 courses like GCSE is the ability to evaluate. Evaluation is making a judgement about things. When you are evaluating something, it is useful to think about something called the 'it depends' rule.

The way one business is affected by a change in interest rates will be different to another because it will depend on a number of things.

Try to think of, and list, 12 different things that might determine how a business is affected by a change in interest rates. We have given you two to start you off:

  • It depends on how much interest rates change.
  • It depends on the size of the income that a person earns - the higher their income, the less they might be affected by a rise in interest rates.

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