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Are high interest rates good?

Compared to recent years, relatively high interest rates are currently being paid on very low-risk investment opportunities such as call money accounts.

This means you can currently invest relatively safely and achieve a good return. So are the present times ideal for private investors and is it perhaps no longer necessary to think about the riskier investment option of shares? 🤔



Background:

High interest rates on low-risk investments (call money, government bonds, etc.) are usually available in times of high inflation.

This is also currently the case. Interest rates have been raised by the central banks in the form of the base rate mainly to combat the high price increases of the last two years. The base rate is the interest rate set by the central bank at which commercial banks can borrow money in the short term and therefore influences the general interest rate landscape and economic activity.

The background to the increase in the base rate is as follows:

  1. The increase of interest rate makes loans more expensive.

  2. This makes it less attractive to buy on credit (e.g. property, cars, technology, etc.).

  3. As fewer purchases / investments are made, demand for products in the economy decreases.

  4. This lower demand then generally leads to falling or less sharply rising prices and correspondingly lower inflation.

The increase in interest rates results in higher costs for borrowers on the one hand and better returns for savers on the other.


Shares vs. call money

Call money is a safe way to invest money at the bank, where you can access the money invested on a daily basis. Accordingly, in times of good interest rates, it is tempting to invest your savings in the form of call money. For example, it is currently possible to earn 4% interest on the money deposited (up to €50,000) with an german online broker. Call money is protected by the deposit guarantee scheme (up to €100,000). This means that even if the bank goes bankrupt, you will get your money back. With individual shares, on the other hand, you can even suffer a total loss if the company goes bankrupt. In addition, liquidity (i.e. how quickly you can withdraw your money) is lower when investing in shares. This is due to the fact that shares can also fall in value below the entry price due to volatility. In this case, a spontaneous sale leads to losses. For this reason, when investing in shares you should only use money that you are unlikely to need in the near future.

Does it even make sense to invest in shares if, for example, you already have 4% in low-risk overnight money? As mentioned, investing in shares does involve more risk, but generally leads to significantly higher returns in the long term. Accordingly, investing in shares makes sense even when interest rates are relatively high and can significantly increase the overall return on savings.

Ultimately, you should always be aware of the principle "the higher the return, the higher the risk". Depending on your personal circumstances and risk appetite, you can then decide to what extent you want to invest in shares in addition to the safe overnight money.

However, if the interest rates on call money were to become significantly higher than at present, the attractiveness of investing in shares would diminish. But in the following section you can see why a further rise in interest rates is rather unlikely.


High interest rates from an economic perspective:

The European Central Bank (ECB) uses the instrument of increasing the key interest rate to reduce inflation.


But high interest rates have some disadvantages:

  • High interest rates lead to higher costs for loans. Companies may therefore be hesitant to invest in new projects and consumers may be less inclined to take out loans, which in turn could reduce economic activity. However, economic growth is an essential pillar for wealth in our society.

  • Burden on public finances: High interest rates can be problematic for governments, especially if they have high levels of debt. In Germany, we have a rather moderate level of public debt, but in southern EU countries in particular, the ECB's high key interest rate could lead to significant burdens, as these countries would have to make extremely high interest payments on their immense debts. Incidentally, this burden is also one of the reasons for the ECB's low interest rate policy before 2021, which protected these countries and enabled investment.

  • Danger of deflation: The opposite of inflation is deflation. In this case, prices would no longer rise, but fall. Sounds good at first? But it is economically dangerous. This is because consumers are tempted to postpone purchases. Why should you buy a new car now for €20,000 when it will probably only cost €19,000 in two months' time? This attitude on the part of buyers can severely slow down the economy.

The ECB is also aware of these disadvantages, which is why it is unlikely that interest rates will be raised significantly above the current level. As the ECB's long-term target is a key interest rate of around 2%, it is even more likely that interest rates will be lowered in the near future.


Conclusion:

High interest rates are initially good for us as investors, as our savings at the bank increase a little and reduce the inflation effect. So although everything becomes more expensive (= inflation), we also have a little more money (thanks to the interest we receive) to buy products.

However, we should not be under the illusion that high interest rates are a long-term solution. They can hold back the economy and often occur in times of high inflation. This means that the interest we receive is of little use to us, as we have to spend more money overall. At the same time, we can also (in the worst case) lose our job because the economy is in crisis. And if you have no income and no money to save, even the highest interest rates are of no use.

Shares offer an alternative for higher returns that are even better able to compete with inflation. But they also involve more risk.

You should therefore choose a good mix of safe investment options such as call money and return-orientated options such as shares.

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