You can think of interest as the price for renting money, whether you are borrowing it or loaning it. When you put your money into a savings account, the bank pays you interest for the use of your money. When you take out a mortgage to buy a house, you pay interest to the mortgage company to use its money. The amount of interest charged or earned depends in part on whether the loan is long-term or short-term.
Although there is no universal consensus on the length of short and long-term interest rates, it is generally assumed that long-term maturation involves a higher degree of risk for the investor.
Short and Long Term Rates
When it comes to interest rates, short-term and long-term are ambiguous phrases. Different financial experts and organizations define the terms differently. For example, the Securities Industry and Financial Markets Association considers bonds with maturities of up to five years to be short term, while the U.S. Department of the Treasury refers to Treasury bills with maturities of 52 weeks or fewer as short-term investments. It might be more useful to refer to shorter-term or longer-term interest rates when comparing investments or loan options.
Identifying Possible Risks
The future is uncertain, and the further you project into the future the less certain it becomes. This uncertainty is translated into increased risk. Regardless of whether an interest rate is referred to as long term or short term, one thing remains consistent: financial products with longer maturities involve a greater level of risk than those with shorter maturities, all other factors being equal. For example, a 30-year AAA-rated corporate bond involves greater risk than a 10-year AAA-rated corporate bond.
Risks Vs. Rewards
One of the prime maxims of investing is that greater reward typically requires greater risk. Since longer-term debt investments involve greater risk than comparable shorter-term investments, long-term interest rates are typically higher than short-term interest rates. For example a 30-year U.S. Treasury Bond typically offers a higher interest rate than a five-year U.S. Treasury Note.
Prevailing Rate Changes
The market price of fixed-interest investments, like most bonds, tends to move in the opposite direction of prevailing interest rates. For example, the price of a 4 percent bond would decline if new bonds were issued with a 5 percent interest rate. No one would pay $1,000 for a 4 percent bond when they could spend the same amount and earn 5 percent on their money. Shorter-term bonds are not affected as greatly as longer-term bonds, since there is less time remaining until maturity, at which time they will be redeemed for full face value, regardless of prevailing rates.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.