Question

Explain why Car loans(Auto Loans), Mortgage, and Credit Card are so different in terms of interest offering based on the formula components, such as Risk Free Rate, Inflation Premium, Default Risk Premium, Maturity Risk Premium and Liquidity Premium. You need to relate those components with the length/duration of lending period, and types of collateral, like housing for Mortgage, vehicle for Auto loans and none for credit card. Use your own thought, opinion and other information you found online.

Answer 1

of terms get the complete understanding of the subject, we must know the meaning of the terms listed in the question i.e. Risk Free rate, Inflation premium, Default Risk premium, Maturity risk premium, Liquidity premium etc . Here are the basic understandings -

Risk free rate - The risk-free rate of return is the theoretical rate of return of an investment with zero risk. The risk-free raterepresents the interest an investor would expect from an absolutely risk-free investment over a specified period of time.

Inflation premium - An inflation premium is the part of prevailing interest rates that results from lenders compensating for expected inflation by pushing nominal interest rates to higher levels.

Default Risk Premium - A default premium is the additional amount a borrower must pay to compensate the lender for assuming default risk. A default premium is generally paid by all companies or borrowers indirectly, through the rate at which they must repay their obligation.

Maturity Risk Premium - The maturity risk premium is the reward a lender can expect for bearing at a longer maturity. This premium arise because it is more risky to lend money at a longer time scale

Liquidity Premium - Liquidity premium is a premium demanded by investors when any given security cannot be easily converted into cash for its fair market value. When the liquidity premium is high, the asset is said to be illiquid, and investors demand additional compensation for the added risk of investing their assets over a longer period of time since valuations can fluctuate with market effects.

In case of mortgage for housing loans, the tenure of the mortgage is longer usually 15 - 25 years and the bank or financial institution generally retain the original deal papers, the risk to the lender is less therefore the overall interest rate is low as compared to car loans and credit cards. Generally housing loans carry a maturity risk premium and liquidity premium apart from regular risk free rate.

In case of credit cards, the tenure of borrowing is usually lower around 1 - 2 months and then bank does not retain any kind of security, therefore they are offered at high interest rates as compared to housing loans and auto/car loans. generally they carry default risk premium apart from regular risk free rates.

The car/auto loans lies in between the housing loans and credit cards in terms of tenure and the risk, therefore the rates offered also lies in between that offered for housing loans and credit cards.