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Interest Rates Basics Explained

Understanding interest rates can seem like wading through thick mud. Actually, they make a lot of sense once you get a handle on the basics of interest rates. We'll start first with the difference between long-term and short-term interest rates.

Long-Term Interest Rates vs. Short-Term Interest Rates

The first thing you need to understand about interest rates is that they are not all the same. The two biggest categories are long-term interest rates and short-term interest rates. Long-term rates are typically higher than short-term rates. The yield curve is the chart that appears when you graph interest rates compared to maturity, or how long the loan is.

Long-term interest rates are usually higher than short-term interest rates.

Why Long-Term Interest Rates are Higher Than Short-Term Rates

Understaning interest rates seems complicated because they only really make sense when you examine them from the perspective of the lender, not the borrower. Once you do that, learning about interest rates is easy.

Imagine a friend asked you to lend them $500 for a couple of days because they needed to cover something until they get paid on Friday. Would you even bother charging them interest? Probably, not. After all, there is really no skin off your nose for lending them money for a couple of days.

Now imagine your friend needs to borrow $500 for a year. Now things are different. During that year you can't use that $500. Not only that, but you could be earning interest on that money if you didn't lend it to them. Charging some sort of interest seems pretty fair under these circumstance.

Banks and other lenders apply the same logic, but on a bigger scale.

If you want $10,000 for six-months, the lender will charge you less interest than if you want $10,000 for six years. In one case, the lender will have the money back to do something else with soon. In the other, the lender will be unable to use that money for anything else for a long while.

Inverted Yield-Curve

Sometimes, it does happen that short-term interest rates are higher than long-term interest rates. This is known as an inverted-yield curve and is typically regarded as a bearish sign for the economy and stock markets.

An inverted yield-curve suggests that something is out of balance in the economy, with either the short-term or long-term rates being "wrong." This then leads to problems that affect the economy either in the form of some sort of correction of one of the rates, or in the form of the "wrong" rate causing a problem elsewhere in the economy.

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