Why do longer term CDs pay a higher rate than the short-term CDs?

By Richard Loth AAA
A:

To address this question, let's employ the concept of distance. In the city, a short taxi ride from your hotel to a convention center might cost about $5.00. However, when you depart from your hotel for a ride to the airport located outside the city limits, you're more likely to pay more than $30.00. The taxi fare is simply a matter of the longer the ride, the higher the fare.

The short answer, then, relates to the difference in a certificate of deposit's (CD) maturity, i.e., the length of time a depositor's money is tied up in or committed to the issuer. So, the longer a bank has contractual use of the funds, the more interest it must pay to attract this type of money from depositors. That's how competition affects financial markets.

Banks are the usual issuers of CDs. Individuals, companies and organizations are commonly the depositors that put their money into these financial instruments. The interest payable on a CD is the cost (to the recipient bank) for using the money. The interest receivable on the CD is the return (to the depositor) for providing the money. CDs are issued for periods ranging anywhere from 90 days to five years, and, generally speaking, the longer the term of the CD, the better the interest rate paid to the depositor.

As a rule, in financial markets, the longer money is being used or provided by a borrower or a lender, respectively, it is going to carry a higher rate of interest. We generally think of banks as lenders, but, obviously, for a bank to lend money it must obtain funds to perform this function. One of a bank's principal funding mechanisms for this purpose is to "borrow" money from the marketplace in the form of CDs. In order to stabilize its funding, it issues some of its CDs with longer maturity dates (two to five years) and is willing to pay depositors a higher rate to attract these funds.

For more on CDs, check out The Money Market tutorial.

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