Q&A - How are businesses affected by changes in interest rates?

The effect of a change in interest rates will depend on several factors, such as:

• The amount that a business has borrowed and on what terms • The cash balances that a business holds • Whether the business operates in markets where demand is sensitive to changes in interest rates

Let’s look at the third factor listed above to examine the implications a little more closely.

Consider the example of households and consumers who like to pay for their goods and services using borrowing such as credit cards or a bank overdraft or loan. Also think about households who have substantial balances outstanding on a mortgage used to finance a house purchase.

An increase in interest rates will mean that the cost of borrowing rises.

In theory, a higher bank base rate will mean that credit card companies such as Visa and Mastercard will also raise the rate they charge borrowers on amounts that are outstanding.

A higher interest rate will also mean an increase in the monthly mortgage payments that are made by home-owners who have mortgages which are charged at a variable rate.
In both cases, the disposable income of consumers and households will fall.

The monthly mortgage payment might rise from say £500 to £550, which means that the household has £50 less disposable income available to spend or save.

If consumers and households think that the rise in interest rates is temporary or short-term, they may simply continue to spend as before. In this case, there will be little effect on demand. However, it might also prompt them to cut back on spending, which would result in lower demand.

Some businesses operate in markets which are very sensitive to changes in interest rates. These markets often involve goods and services where the purchase is financed by debt and where the price paid is relatively significant compared with the customer’s income. For example:

• Housing (mortgages)
• Motor vehicles
• Holidays
• Major purchases of consumer goods – e.g. new kitchen equipment, audio-visual systems