Understanding why interest rates rise and fall can help you take advantage of their impact

Interest rates are often called the cost of money. Actually, they are the price you pay, or someone pays you, to rent money for a specified period of time. When you open a savings account, for example, or buy a guaranteed investment certificate (GIC), the financial institution is borrowing your money and paying you rent for its use. It then rents your money to others and makes a profit by charging them a higher rent than it is paying you.

You probably have noticed that the prices change on signs posted by institutions in the money-renting business, and sometimes these prices go up or down quite rapidly. Why do interest rates bounce around so much? The most important reason is inflation. When inflation is high (or expected to be high), lenders know that they eventually will be paid back with dollars that are worth much less than the ones they rented out. So they insist on a higher interest rate to compensate them for the loss of their money’s purchasing power.

But interest rates move up or down even if inflation expectations remain constant. That’s because when the economy is humming along, businesses can find more opportunities to profitably use the money they borrow from you, and are willing to pay a higher rent for it.

Another powerful force is the Bank of Canada, which sets national monetary policy and supervises banking operations throughout the country. When it fears that the economy is expanding so fast that more inflation may result, it tries to cool things by pushing up short-term interest rates high enough that businesses and individuals won’t want to borrow so much money. In contrast, when the economy is contracting, the Bank of Canada pushes rates down to stimulate borrowing and spending in hopes of boosting the entire economy.

Changes in interest rates can significantly affect different types of investments. Some stock prices may decline as companies pay more for loans and raw materials, causing lower profits. Interest rate changes also have a predictable impact on at least one money-renting vehicle: bonds. Rising interest rates drive bond prices down, and falling rates drive them up. The reason: On the day a bondholder decides to sell his or her bond, current market rates will determine the price. The bondholder will sell for less when interest rates are higher than the bond’s rate, and for more when interest rates are lower. Usually, the more years the bond is from maturity (the date of repayment), the bigger the price change.

When you’re deciding how to allocate the money in your RRSP, you are typically choosing among three options: renting your money in different ways (through bond funds, money market funds, etc.); investing in earning potential (a stock fund); or a mix of the two. As you plan your asset allocation, you will want to ask yourself: Are money-rental prices more attractive than the growth potential of your stock fund? Are interest rates high enough to cover the inflation you expect and still give you a satisfactory return? Take these questions seriously they’re very much in your interest.