What is Interest Rate Risk?

Interest rate risk refers to the potential for an asset’s value to fluctuate due to changes in underlying market interest rates. This risk is inherent in assets influenced by shifting interest rates, such as bonds, and is crucial for both investors and borrowers to understand.

Interest Rate Risk’s Impact on Investors

Fixed-income investments like bonds are particularly susceptible to interest rate risk because their primary value to investors comes in the form of interest payments. Interest rates for bonds and other fixed-income securities are influenced by various economic factors, including inflation, economic growth, government policy, and the credit risk of the bond issuer.

As a result, the prevailing interest rates on new bonds are constantly fluctuating. Because investors can sell bonds on the secondary market before they reach maturity, the value of your investment can change daily. If interest rates drop and a comparable bond to one you own is selling with a lower coupon rate, the market value of your bond will increase because it offers a more attractive income stream than what’s currently available.

Interest Rate Risk’s Impact on Borrowers

Interest rate risk also affects borrowers, particularly when choosing a repayment term and interest rate type for a loan. Loans function as assets to the financial institutions that originate them, and the terms of these loans can significantly impact the borrower’s financial situation.

Repayment Term

When a lender originates a loan with a fixed interest rate, they give up the opportunity to use those funds for other loans. If market interest rates for new loans increase, the lender can’t simply recall the loan and originate a new one at a higher rate. To compensate for that risk, lenders typically charge higher interest rates on loans with longer repayment terms.

Variable vs. Fixed Interest Rate

If lenders anticipate that interest rates will increase, they may offer a lower upfront rate if you choose a variable rate over a fixed rate. This allows the lender to adjust your loan’s rate along with market rates, effectively offloading some of the interest rate risk onto you. Conversely, if rates are likely to go down, variable-rate loans may cost more than fixed-rate loans upfront.

How to Minimize Your Interest Rate Risk

Whether you’re planning to invest in fixed-income securities or take out a loan, here are some steps you can take to minimize your exposure to interest rate risk:

Diversify Your Portfolio

If you plan to invest in bonds, diversify your portfolio by investing in different types of bonds with varying degrees of risk. Additionally, spreading your investments across different asset classes, such as stocks, funds, and real estate, can ensure that you’re not overexposed to risks associated with any individual asset.

Invest in Varying Durations

Fixed-income securities with shorter durations don’t create as much interest rate risk because there’s less time for market rates to change drastically. At the same time, bonds with longer durations may offer higher yields, so having a good balance of the two can help you minimize your risks without sacrificing your return potential too much.

Choose Shorter Loan Terms

When borrowing money, opt for a shorter repayment term if you can afford it. While the lower monthly payment of a longer repayment term is tempting, you may end up with a higher interest rate and more total interest charges.

Opt for a Fixed Interest Rate

In most cases, it’s best to choose a fixed-rate loan over a variable-rate alternative because it prevents you from taking on the risk of fluctuating market rates. However, it can make sense to opt for a variable-rate loan if you have good reason to believe that interest rates will decrease over time. An adjustable-rate mortgage loan can offer a lower fixed rate for a handful of years, giving you some time before you need to worry about changing market rates.

The Bottom Line

Whether you’re an investor or a borrower, it’s not possible to completely eliminate the risk that interest rates can have on your investment portfolio or loan. However, understanding how interest rate risk works and the steps you can take to minimize the impact of that risk can help you make the most of your financial situation and reach your goals.

For expert mortgage services and advice, contact O1ne Mortgage at 213-732-3074. Our team is here to help you navigate the complexities of interest rate risk and find the best solutions for your financial needs.