Sow My Seeds

Lately, there has been quite abit of talk of another interest rate rise.
Wall Street went on a yo-yo up and down in response to Fed comments.
How may an increase in interest rates affect stocks?

Interest Rates - What Are They?
Interest rate is basically the cost of borrowing money. If you have bought a house and taken up a loan, then you would probably be aware that you pay an interest rate for borrowing money from the bank. Likewise, businesses borrow money and pay an interest rate. The Federal Reserve (Central Bank of America) uses interest rates to control the amount of money available, hence influencing our inflation rates. If the economy is showing signs of growing too fast, then, the Central Bank would consider to increase interest rates to control the amount of money available for spending, thus controlling inflation rates.

Debts Becomes More Expensive
With an increase in interest rates, borrowing money becomes more expensive, and hence, the loan you had taken from the bank will cost more. You end up setting aside a bigger portion of your salary to pay the bank loan, and hence, less money on your hands for spending. Likewise, the same happens to businesses. Businesses borrow money to fund operations, projects and seek expansion. An interest rate rise will mean such areas of the business will be affected and hence, affect profit margins. With poorer future prospects, would you as an investor still be willing to invest in the company? Less demand for a stock indirectly translates to poor stock performance. 

Thinking Twice On Expansions
As interest rates rise, companies looking to expand their operations will think twice before doing so. As banks make borrowing more expensive, companies may become reluctant to borrow too much money, and hence, shelf intentions for expansions.

Companies With High Debts
It also pays to assess if a company has a high level of debt. This can be done by assessing a company's debt ratios before investing in their stock. A high level of debt will mean more is needed to meet interest payments, rather than ploughing back to the business or paying it out to you in the form of dividends.

Banks - A Different Side Of The Story
As for banks, they make the bulk of their money from interests. Their earnings come from the difference they charge borrowers and the deposit rate they pay out to savers. When the interest rate rises, you will likely hear from your bank about increasing your home loan rate, but hardly would you hear your bank contacting you about an increase in your savings rate. Which means, the banks earn a bigger spread between the borrowing and savings rate. Hence, an interest rate rise may be beneficial for banks.

The Bottom Line
So, are stocks (other than banks) expected to drop with an increase in interest rates? The answer is, we don't know. We can never say with confidence that a particular factor will affect stock prices, as performance is always influenced by a myriad of factors. A thousand or ten thousand reasons inter-related to each other may affect stock prices.

But! We now know that, before investing in a stock, it is best to understand the nature of business and how the business operates financially. A company may seem to be in the limelight for great expansions, deals, with their brand everywhere on buses and newspapers. But we have to assess whether the company is operating on a healthy level of debt, or a high level of debt. On a healthy level of debt, we are certainly assured that any interest rate hikes will not affect the stock price too negatively.