Short-term interest rates apply to short-term loans. This concept of a short term is defined by a timeframe smaller than one year. In a stable and healthy economy, short-term interest rates on loans tend to be lower compared to long-term loans. Due to the fact that the amount borrowed is less relative to long-term loans, there is a lower risk associated with the investment. The overnight rate applies to how banks are obliged to hold a certain amount of cash in their reserves. If they do not have enough money, they would borrow money from another bank to meet their obligations. The overnight rate applies to this sum of borrowed money.
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Long-term interest rates are associated with long-term loans. These rates apply to the large sums of money that people borrow to buy a house and some of the debt-based instruments that are traded between financial institutions. In light of the risk that is tied to long-term loans, the interest rates on these loans are normally higher in relation to short-term loans. The mortgage is a well-known example that is connected to long-term interest rates. These loans are usually associated with extended periods of time such as 20 to 30 years.
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The differences between short-term rates and long-term rates largely pertain to the type of loan. Where short-term loans are associated with short-term interest rates, long-term loans are generally associated with long-term interest rates. Each relates to different classes of investments. Most, if not all, liquid and short-term debt carry short-term interest rates, whereas illiquid debt assets carry long-term interest rates.
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Interest rates indicate the health of the economy. If short-term interest rates are higher than long-term interest rates, then it indicates there's something wrong with the economy. How does this add up? When there is something wrong with the economy, it is normally captured in widespread uncertainty. Beyond normal citizens, this uncertainty is most visible in investors and market speculators. Their overall sentiment physically shifts from optimistic to pessimistic. It is innate to humans that we do not like being uncertain. When there is uncertainty in an economy, market participants become fearful since they do not know what will happen with their investments. This fear is embodied in how investors and speculators pull their capital out of the speculative market and keep it in safe forms such as cash or secured bonds. It is this fear and uncertainty that is directly correlated with interest rates in the economy.
Uncertainty changes lenders' approach to debt-based instruments like bonds, commercial paper, business loans, and credit lines. Economic uncertainty instills doubt in lenders' faith that borrowers will repay their debt. This doubt is the root reason why short-term interest rates exceed long-term interest rates in economies. It reflects how lenders want to compensate for the potential scenario of lost money by demanding a bigger repayment from borrowers.
Economic uncertainty can come at the hand of a wide range of causes. Political feuds and conflicts can render investors uncertain about the future of the financial market. Social tension in a country can also cause doubt among market participants since it is unclear what effects the ultimate solution will have on the economy as a whole. The consequences of large-scale events are usually closely monitored by economists looking to present market projections. The market in itself can determine certainty and interest rates. When the economy is experiencing an expansive phase where the market is soaring, employment is rising, and households are becoming wealthier, lenders are more prone to handing out loans with lower short-term interest rates compared to long-term interest rates. This illustrates lenders' confidence in the economy and the longevity of prosperity. However, once fortune takes a turn, interest rates reflect investors' sentiment, circling back to the aforementioned explanation of doubt and uncertainty.
The events surrounding the COVID-19 pandemic of 2020 provide a perfect example of the association between interest rates and the economy. When the pandemic struck in early 2020, and global markets tumbled as the world went into lockdown, the United States federal reserve bank responded to the crisis by dropping interest rates as low as they possibly can to 0.25%. Accompanying this occurrence was the unprecedented number of stimulus checks that the government handed out to eligible citizens. This was all followed by the single greatest stock market rally in human history. The low interest rate captured the boom that economies around the world were experiencing and within a few months, markets were back up to their previous all-time highs. However, with inflation surging to its highest point in 40 years, the federal reserve bank also had to react to the dangers of hyperinflation. Consequently, interest rates were finally hiked in early 2022 and the economy reacted appropriately. With markets soaring at unsustainable heights, uncertainty befell investors and the market began to decline.
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Interest rates are percentage amounts of money that a lender receives on top of their money for loaning money to a borrower. These rates are generally classified under short-term interest rates and long-term interest rates. Short-term rates are usually lower compared to long-term rates due to the associated risks and size of the loan. When short-term interest rates are higher than long-term interest rates, economists usually foresee economic trouble. On the contrary, when long-term interest rates are higher than short-term interest rates, it is indicative of economic stability. Short-term rates are associated with short-term loans and long-term rates are related to long-term loans.
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Video Transcript
Short- vs. Long-Term Interest Rate
Your best friend has just come up to you and is asking to borrow $400 so he can purchase his dream car. He says he will pay you back at the end of the week when he gets paid. What did your friend just do? He just made a short-term loan with you as the lender and him as the borrower. Now, it's up to you to decide whether or not to charge interest. If you do, the interest rate that you charge on a short-term loan is referred to as the short-term interest rate.
Your friends must think you're rich because now another friend also comes up and asks you for $400 to help him pay his rent for the month. He says that he can't pay you back until the following year or maybe even another year after that. This friend has just started his own business, and the business is still not making enough to support him. If you give him the $400, you have given your friend a long-term loan. If you decide to charge your friend interest, the interest rate you charge on this long-term loan is referred to as the long-term interest rate.
Differences
The major difference between a short-term interest rate and a long-term interest rate is the length of time it takes for the loan to be paid back. A short-term loan is one that is payable within a period of less than or equal to one year while a long-term loan is more than one year. Another difference is that long-term interest rates are usually higher than short-term interest rates. For example, your bank will charge you a lower interest rate on a $10,000 loan that you pay back within six months than on the same $10,000 loan but paid back in five years.
Why is this? Well, think back to your two friends. Which of these friends are you more willing to just give the money to without asking for interest at all? Isn't it the $400 friend that's paying you back within a few days? Because you'll be getting the money back within a short period of time, you won't really miss this money. But you might want to charge the other friend interest on his loan because you won't see that $400 for a while nor can you use that $400. If you had that $400, you can save it or invest it or use it any way you want, but since your friend can't pay it back for a while, you are $400 poorer for a while.
These interest rates are actually indicators of how the economy is doing. When the economy is working as it should, long-term interest rates are higher than short-term interest rates. When something is wrong with the economy, then you might see short-term interest rates being higher than long-term interest rates.
Lesson Summary
Let's review. A short-term interest rate is the interest rate charged on a short-term loan. A long-term interest rate is the interest rate charged on a long-term loan. The major difference between a short-term interest rate and a long-term interest rate is the length of time it takes to pay back the loan. Also, long-term interest rates are usually higher than short-term interest rates. These interest rates indicate whether the economy is working as it should or not.
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