Why might you be willing to make a loan to your neighbor by putting funds in a savings account earning a 5% interest rate at the bank and having the bank lend them the funds at a 10% interest rate, rather than lend them the funds yourself? Part 2 A. There is no way to diversify your savings except with the help of a bank. B. Your neighbor suffers from information asymmetry. C. There will always be a moral hazard problem in lending to a friend or neighbor. D. The costs of writing up the loan contract might exceed the 5% difference between your deposit rate and the bank lending rate.
The correct answer and explanation is:
The correct answer is D. The costs of writing up the loan contract might exceed the 5% difference between your deposit rate and the bank lending rate.
Explanation:
When lending money directly to a neighbor, there are several potential issues and costs involved that could make it more practical to go through a bank. First, lending money to an individual typically requires a formal agreement to protect both parties involved. Drafting a legally binding contract to ensure that the loan terms are clearly defined can incur legal costs, time, and effort. If the loan is not repaid as agreed, the process of enforcing the terms of the contract could also be costly.
On the other hand, putting the money into a savings account at a bank and allowing the bank to lend the funds offers a simpler solution. The bank has established processes for lending money, including assessing the borrower’s creditworthiness and handling repayment. Since banks have the infrastructure and experience in managing loans, they can offer the service more efficiently, often for a small fee or no additional cost to you, the lender.
Additionally, the interest rate spread (5% difference between the deposit rate and the bank lending rate) might seem attractive at first. However, the transaction costs associated with direct lending, including writing up the loan contract, monitoring repayments, and dealing with any potential defaults, could outweigh the 5% difference. Therefore, it might be more efficient and less risky for you to use the bank as an intermediary, rather than taking on the burden of managing the loan yourself.
This makes option D the most appropriate choice, as the administrative and legal costs involved in direct lending can easily exceed the benefits of the higher interest rate.