Difference Between Long-term and Short-term Interest Rates

Long-term vs Short-term Interest Rates
 

Interest is the cost that needs to be incurred by a borrower when borrowing money. The interest rate that is applied will depend on the length of time for which the funds are borrowed. Long term interest rates apply for long term borrowings while short term interest rates apply for short term borrowings. There are a number of differences aside from the period of time that represents short term and long term interest rates. The article offers a clear explanation of long term and short term interest rates and compares the similarities and differences between the two.

Long-term Interest Rates

As the name suggests a long term interest rate is an interest rate that is applied for a longer period of time, usually above 10 years. Such long term interest rates are usually associated with debt instruments, financial securities and investments that require a long term commitment. Long term interest rates tend to be more stable as any major fluctuations that occur during the short term will be evened out with time. Securities that carry long term interest rates include treasury and corporate bonds, certificates of deposit and long term interest rates are also associated with long term bank loans that usually span over a number of years.

Short-term Interest Rates

Short term interest rates usually apply for shorter periods of time, and are usually associated with securities and financial assets that have a maturity period of less than a year. In the United States, the fed controls the monetary policy by setting the federal funds rate. The federal funds rate is the interest rate at which banks lend funds (federal funds) to other banks. Short term interest rates change directly with the federal funds rate; if the fed funds rate increases, short term interest rates too will increase and vice versa.

Changes in the short term interest rates can largely affect the payments that need to be made on credit card debt. Credit cards that have a variable interest rate will experience interest rate fluctuations directly related to short term interest rate changes. Mortgages are usually given on long term basis and do not experience large short term fluctuations. However, taking out an adjustable rate mortgage (ARM) will result in interest rate fluctuations, since interest rates for an ARM are determined on a short term basis.

Long-term vs Short-term Interest Rates

Long term interest rates and short term interest rates have a number of differences aside from just the periods of time that they represent. Short term interest rates are associated with financial assets that have maturity of less than one year, and long term interest rates are associated with assets that have a maturity of more than a year.

Long term interest rates tend to be higher than short term interest rates since there is a higher risk involved with long term interest because funds lent are tied up for longer periods of time, with higher possibility of default. Short term interest rates are subject to higher levels of fluctuation during the short term since economic activities can have a direct and immediate impact on these rates. This is not the case with long term interest rates as fluctuations can be easily evened out with time.

Short term interest rates and long term interest rates affect the economy in similar ways. Interest rates whether short term or long term can affect the economic growth of the country; low rates promote growth by promoting borrowing and investing, and high rates deter growth by deterring borrowing and spending.

Summary:

Difference Between Long-term and Short-term Interest Rates

• As the name suggests a long term interest rate is an interest rate that is applied for a longer period of time, usually above 10 years.

• Short term interest rates usually apply for shorter periods of time, and are usually associated with securities and financial assets that have a maturity period of less than a year.

• Long term interest rates tend to be higher than short term interest rates since there is a higher risk involved with long term interest because funds lent are tied up for longer periods of time, with higher possibility of default.