Question

1. Explain the two ways in which banks can charge interest on loans? Provide examples of the types of loans that would be priced based on these two types of interest rates.  

Answer 1

Banks are free to set the Interest rates for the loans but they have to face market competition also with other banks. So, they choose some criteria for setting it.

- Credit Score are taken into account while setting interest rates and the borrower with a better score gets a lower interest rate on a loan.

- When a loan is secured by collateral, the risk of default by the borrower decreases and hence the risk premium charged may be lower, reducing the rate of borrowing.

Apart of this,the Shorter the tenor of the loan, lower the risk, since the ability of the borrower to repay the loan is less likely to change and hence lower the rate of interest.

The interest rate for each different types of loan depends on the credit risk, time, tax consideration and convertibility of the particular loan .

Personal Loan , Credit Card Loan is given on the basis of credit score of the individual. How is the repaying capacity of the individual? Is he credible or not? Banks check his payment details history then fix interest rate for him.

Risk refers to the likelihood of the loan being repaid.A greater chance that the loan will not be repaid leads to higher interest rate levels. If the loan is " secured" meaning there is some sort of collateral that the lender will acquire in case the loan is not paid back i.e. ( such as a car or a house)the rate of interest will probably be lower. This is because the risk factor is accounted for by the Collateral.