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Chapter 21: Problem 5

Suppose you can receive an interest rate of 2 percent on a certificate of deposit at a bank that is charging borrowers 6 percent on new car loans. Why might you be unwilling to loan money directly to someone who wants to borrow from you to buy a new car, even if that person offers to pay you an interest rate higher than 2 percent?

Short Answer

Expert verified
Depositors might be unwilling to lend to someone directly, even at higher interest rates, due to higher default risk, administrative burdensome, liquidability concerns, and the possible desire to keep the investing process simple and safe.

Step by step solution

01

Risk Factor

The risk involved with lending money directly to someone is significantly much higher compared to depositing money at a bank, which is comparatively safer and protected by various legislations. Even if the person offers an interest rate higher than 2 percent, default risk exists and may lead to a total loss of the lent money.
02

Administrative Requirements

If a decision is made to lend money directly, it involves administrative tasks such as drafting and enforcing contracts. This is a time intensive task and requires knowledge in law. A mistake in any of these processes can lead to severe financial consequences.
03

Liquid assets and Time factor

If you invest in a certificate of deposit, you can always withdraw the money (with a penalty in the worst case). However, if you loan someone money directly it's not guaranteed when (or if) the money is paid back, making the funds much less liquid.
04

Purpose of Deposit

Considering this, there's a possibility the investor may not wish to act like a lender or a bank. By simply depositing in a bank, they may want their money to be safe and grow, albeit slowly, without the additional risk and effort.

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