For those seeking credit, the interest rate is one of the most important factors they consider. That’s because it represents the money one pays to borrow the cash in exchange for a promise to pay it back after a given period. For example, when you take out a loan like a mortgage, payday loan, or a personal loan, after a predetermined period, you have to pay the lending company interest for using its money in addition to the principal amount and other fees.
On the other side of the equation, interest rates are equally important for savers, cash holders, and investors who rely on fixed-income investments. In this case, interest rates represent the money one earns from cash deposits or investments. For instance, when you deposit your money in a bank account for a given period, the bank pays you interest for using your money. So, when you withdraw the money you deposited, it’ll be more because it has earned interest over time.
What Is an Interest Rate?
In lending, it refers to the amount of money the lender charges the borrower, usually a percentage of the principal (loaned) amount. The rate is usually calculated annually and is called the Annual Percentage Rate (APR).
In investments and savings, the interest rate is the cash earned from your investments or savings, such as a certificate of deposit or a savings account. This type of interest rate on deposit accounts is referred to as Annual Percentage Yield (APY).
Typically, the interest rate is the price for renting out cash or assets (e.g., vehicle, house) whether you’re loaning them or borrowing them. The interest rate earned or charged depends partly on whether the loan is short-term or long-term.
Factors That Affect Interest Rates
Interest rates differ based on:
- Government directives to the central bank
- The investment’s term to maturity
- Market supply and demand
- The currency of the principal sum borrowed or lent
- Borrower’s perceived default probability
- The collateral amount
- Reserve requirements
- Other special features such as call provisions
- Compensating balance
- And more
Short-Term vs. Long-Term Interest Rates Definitions
Short-term and long-term interest rates are ambiguous phrases. Various financial organizations and finance experts define them differently.
For instance, the U.S. Department of the Treasury considers treasury bills with a maturity of 52 weeks or fewer as a short-term investment. In contrast, the Securities Industry and Financial Markets Association refers to bonds with maturities of up to 5 years as a short-term investment.
Short-Term Interest Rate Definition
Short-term interest rates are interests applied to financial assets and securities with maturity shorter than one year. Nationally, short-term interest rates are determined by the central bank—The Federal Reserve System.
The Federal Reserve’s Federal Open Market Committee (FOMC) sets the federal funds rate to control the monetary policy in the U.S. The federal funds rate represents the interest rate that banks charge when lending to other banks. This enables it to fulfill its mandate of maintaining price stability and promoting economic growth.
Short-term interest rates fluctuate every time the Fed funds rate is changed. If it increases, the short-term interest rate increases and vice versa.
These fluctuations in short-term interest rates impact money lent or borrowed for a short duration. For example, they impact credit card payments, but they don’t affect mortgages because they are offered long-term. However, interest rates fluctuations impact adjustable-rate mortgages (ARM) since these rates are based on a short-term basis.
Long-Term Interest Rate Definition
Long-term interest rates are interests applied to financial assets with a maturity of one year or longer. Debt instruments, investments, and financial securities that need long-term commitments are under this category.
Financial securities with long-term interest rates include corporate bonds, term bonds, treasury bonds, real estates, and notes payable. Long-term interest rates are deemed more stable as they occur over a longer duration meaning any short-term fluctuation is evened out over time. The market forces of supply and demand determine the long-term bond pricing equilibrium, which in turn help set the long-term interest rates.
Understanding Interest Rates and Bonds
Owning a bond makes you eligible to receive a cash payment in the future, which will come in the form of periodic interest payments plus the principal after the bond matures. However, bonds face interest rate risk because when the rates increase, their prices decrease.
Interest rates respond to the levels of inflation in the economy. If the prices increase in the economy, the central bank increases its target rate to stabilize the economy. Thus, the actual bond’s face value is eroded by inflation, which is a major concern for longer maturity debts.
Prevailing Rate Changes
The pricing of fixed interest investments such as bonds tend to go opposite the interest rates prevailing. For instance, a 4% bond price would decrease if issuing new bonds with a 5% interest rate. That is because investors won’t be willing to pay $5000 for a 4% bond when they could pay the same amount of money and make 5%. Shorter-term bonds are not as affected by the changes in rates as the longer-term bonds. That’s because, with short-term bonds, maturity and the chance to redeem the bond for full face value are reached at a quicker rate.
Risk and Interest Rates
Generally, long-term rates are higher than short–term rates because the funds are tied up for a long period posing a higher risk of default. In simple terms, there is an increase in uncertainty attributable to the passage of time.
The lender charges higher interest rates to compensate for this uncertainty. For example, a 10-year AAA-rated corporate bond involves less risk compared to a 30-year AAA-rated corporate bond.
Measures of Risk
When investing in bonds, you must assess the interest rate risk and credit risk. Interest rates influence bond prices. Interest rate risk is the fluctuations in bond pricing because of the prevailing interest rates. Therefore, changes in long-term versus short-term interest rates can influence different bonds, including term bonds, in various ways.
On the other hand, credit risk is the risk that the bond issuer won’t pay back the scheduled principal and interest payments. This default or negative credit event probability influences the bond pricing. The higher the risk of default possibility, the higher the interest rates demanded by investors to compensate for assuming that risk.
U.S. Treasury bonds are issued by the U.S. Department of the Treasury that fund the government’s operations and are free from the risk of default. Therefore, the investors trust that there is no way the U.S. government can default while making the interest and principal payment on these financial instruments. Depending on the time until they mature, they can either be referred to as bills, bonds, or notes.
Risks vs. Rewards
The prime maxim of investing says, “The greater the risk, the greater the reward.” Therefore, long-term investments pose a higher risk compared to short-term investments.
Although investing in long-term investments may involve greater risk than short-term investments, the investor is likely to reap more. For instance, a 5-year U.S. Treasury Note offers a lower interest rate than a 30-year Treasury U.S. Bond, but the bond has higher returns than the Note.
Interest Rates, Bonds, and Inflation
Interest rates, bond pricing, and inflation expectations correlate with each other. The nation’s central bank dictates the movements of the short-term interest rates, which affect bonds with different maturity terms based on the market’s expectations of the inflation levels in the future.
The bond’s cash flow timing is important. If the market participants anticipate upcoming inflation, the interest rates, and bond yields will increase (prices will fall) to compensate for the purchasing power loss of future cash flows.
If a short-term interest rate change does not affect the long-term interest rates, then the long-term bond yield and price will not be affected. However, if there’s a change (no change when the market perceives one is necessary) in short-term interest rates that influence the long-term interest rates, it will impact the bond’s price and yield.
In simpler terms, changes in short-term interest rates have a higher impact on short-term bonds, whereas changes in long-term interest rates have an impact on long-term bonds.
What Is the Difference Between Short-Term and Long-Term Loans?
A term loan is a common phrase in business financing that refers to the lump sum of money that a loan company deposits into the borrower’s business account. The borrower is then supposed to repay that exact amount plus interest after a given period.
Short-term and long-term loans differ based on the length of their repayment period, interest rates, eligibility requirements, loan cost, and loan amounts.
How Short-Term and Long-Term Loans Differ
Typically, any loans that require you to repay within 3 and 12 months are short-term loans. Sometimes this duration can extend up to 18 months. Long-term loans usually require more than 24 months for repayment. That all depends on the intended use of funds, the lender, your business financials, and possibly the loan program you’re taking part in.
Fixed vs. Variable Interest Rates
Banks charge both variable and fixed rates. While fixed rates stay the same throughout the loan term, variable rates vary with the prime rate based on the federal funds rate.
With fixed rates, you make interest payments initially, and you pay a greater percentage of the principal amount over time. On the other hand, when variable rates increase, the loan payment also rises. With both, you can make an extra payment toward the principal amount payment, which can help you clear off the debt sooner.
Why Do Short-Term Loans Have Higher Interest Rates
When repaying a loan, you must pay interest in addition to the principal amount and other charges. It’s easier to qualify for short-term loans like payday loans; however, lenders charge higher interest to compensate for the risk of loaning to high-risk borrowers. When you pay for the high interest, you’re paying for the speed of the loan approval and the increased risk of default.
Therefore, the cost of your loan depends on how the lender views your application information. The APRs for short-term loans can go up to 300%. However, it’s good to note that even though short-term loans have higher interest rates, it does not necessarily mean they are costlier than long-term loans. On the contrary, long-term loans are pricey because you hold on to the loan for longer, which means you’ll pay more interest, and the risk of default increases over time.
Short-Term vs. Long-Term Interest Rates: Summary
Short-term and long-term interest rates differ in the following ways:
- Short-term interest rates are associated with financial assets with a maturity period of less than one year. In contrast, long-term interest rates are associated with financial assets with a maturity period of one year or longer. Typically, the long-term interest rate is applied for a period of 10 years.
- Long-term interest rates are not subject to high levels of fluctuations like short-term interest. Short-term interest rates are the most affected because economic activities have an immediate and direct impact on these rates, which isn’t the case with long-term rates.
- Long-term interest rates are higher than short-term interest rates because they are subject to higher risks since funds (lent or borrowed) are tied for extended periods with an increased probability of default.
Both short-term and long-term interest rates influence the country’s economic growth. That’s because low rates can promote growth since more people will invest and borrow money, and high rates will deter spending and borrowing.