What considerations account for the fact that interest rates differ greatly on various types of loans? Explain with the following examples:
a. A 10 year $1000 government bond.
b. A $20 pawnshop loan.
c. A 30-year mortgage loan on a $67,000 house.
d. A 24 month $8,000 commercial bank loan to finance the purchase of an automobile.
e. A 60 day $100 loan from a personal finance company.
You have asked two questions, I have eliminated one of them and am giving you a response for the other.
Interest rates are not constant for all loans that are given. They vary based on several factors. A few of them are:
Risk of a default: When a loan is given, the issuer has to keep in mind the risk of a default. To make up for any extra risk that is involved is some cases, a higher rate of interest is charged. For example, in the cases provided, a 10-year government bond is very secure and the person buying the bond is assured of getting the interest on time and also getting back the principle. This would make the interest rate here relatively low. Similarly in the case of a mortgage, the bank has the house as a security, which it can sell if the loan is not repaid. An automobile is also a security but the value of the automobile decreases as it is used. This makes the interest rate lower for automobile higher the mortgage. Personal loans and those given by the pawn broker have a high risk of default. This makes the interest rate charged quite high.
Liquidity: The faster a loan is repaid, the lesser is the profit that the issuer stands to make. To accommodate for this, the interest rate will increase. A 30-year mortgage gives the issuer a long period over which interest is collected compared to a 2- year loan for an automobile. The interest rate for the car loan is likely to be higher than the mortgage.
Costs involved: If the costs involved while issuing the loan in checking on the current financial situation of the person taking the loan, the credit history, cost of disbursement of funds and other similar factors is higher, it reflects on the rate of interest. For example a person buying a government bond does not have to spend as much effort in checking on the capability of the government to pay back, while a personal finance company would have to put in more effort analyzing the financial situation of the person the loan is being issued to. This would make the interest rate on the bond lower than the rate on the personal loan.