Question

1. Why would a lender charge a lower contract interest rate coupled with a front-end fee? Why not simply incorporate the effective rate into the contract rate?

2. Because inflation causes real interest rates to be lower, won’t lenders simply factor inflation into their contract rates so that the real rate remains constant? With rational borrowers and lenders, shouldn’t adjustments for anticipated inflation cancel out inflation’s impact?

Answer 1

1. Lender would be charging lower contract interest rate coupled with front end fees because they want to restore a part of contract quickly in order to protect themselves from any kind of fluctuations regarding external environment in relation to interest rate fluctuations or other macro fluctuations.

it will also help them to gain on the time value of money by accepting the cash in hand so they will not have the effect of discounting on that portion which has been received at the present.

2. The real rate of inflation can never be predicted in advance so the real interest rate cannot be adopted while providing with a contract as real interest rate will be dependent upon disposal of the impact of inflation which can never be possible without properly analysing the overall impact of inflation and the rate of inflation so rate of inflation will continuously changing upon the demand and supply in the economy and it is exposed to various micro risk, it is never adequate and appropriate to adopt a real rate of interest as inflation can never be properly accurately estimated in advance.