Question

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

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

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.

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.

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.

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.

Key concepts

Interest Rates

Interest rates play a critical role in financial decisions. They act as the cost of borrowing money or the reward for saving money. In the context of our exercise, the certificate of deposit at the bank offers an interest rate of 2%, which is relatively low compared to the 6% interest rate charged by the bank for car loans.
This interest rate difference reflects the risk and duties undertaken by the bank. The bank profits by lending out money at higher rates than it pays to savers, but they also assume the risk of not getting it back. When a borrower defaults, the bank is shielded by funds and legal methods to minimize losses and protect depositors. Thus, interest rates offered play a crucial role in measuring the risk and potential gain from investments or loans.
When lending directly, even at a higher interest rate, one must consider the increased risk of losing your investment compared to the safer bank offering.

• An interest rate is essentially the cost of money expressed as a percentage.
• Higher interest rates typically imply higher risk of default.
• Banks offer interest rates based on the market conditions and risk assessments.

Default Risk

Default risk is the possibility that a borrower will not repay a loan as agreed. When dealing with banks, the risk is minimized through screening processes and risk assessments. However, when deciding to personally lend money, one faces significantly higher default risks.
In the exercise, even if the borrower offers a higher interest rate than the bank, there's no guarantee they will not default. Banks limit the risk by diversifying their loans and having security measures. Direct lenders do not have these safety nets, which significantly raises the likelihood of loss.
Considering this risk is vital for anyone contemplating personal lending. The potential for default must always be carefully weighed against the promised return.

• Default risk is the chance of non-repayment.
• Banks carry out thorough screening to lower this risk.
• Personal lending exposes one to a higher likelihood of default.

Liquidity

Liquidity refers to how easily an asset can be converted into cash without significantly affecting its value. In the context of the exercise, a certificate of deposit offers a level of liquidity, albeit with some penalties for early withdrawal.
This liquidity is something one forfeits when loaning directly to someone for a car. Direct loans are not easily convertible back to cash, and one may have to wait for the borrower to pay back according to the agreed schedule, or possibly even longer if issues arise.
Hence, potential lenders must consider how quickly they may need their money back—a key reason why many choose the safer option of traditional banking.

• Liquidity measures how quickly assets can be converted to cash.
• Bank deposits typically offer easier liquidity compared to personal loans.
• Lack of liquidity in personal loans can be risky if funds are needed suddenly.