Question

Consideration of the effects of default risk and collateral suggests which of the following should be the ordering of the interest rates on different types of household credit, with earlier items in the list having the higher interest rates?

Answer 1

The ordering of interest rates on different types of household credit is based on the level of default risk and the presence of collateral, with higher risks and lack of collateral leading to higher rates.

Step-by-step explanation:

The consideration of the effects of default risk and collateral implies that the ordering of interest rates on different types of household credit should be aligned with the level of risk and security associated with the loan. Loans to borrowers with a history of late payments or a higher probability of default risk will have higher interest rates to compensate for the increased risk. Similarly, loans without collateral tend to carry higher interest rates than secured loans. Conversely, loans to borrowers who are more financially reliable or where the overall interest rates in the economy have fallen, will generally have lower interest rates.

Hence, the ordering from higher to lower interest rates would look something like this:

1. Loans to borrowers with a history of late payments
2. Unsecured loans (no collateral)
3. Loans made when interest rates were relatively lower and have since risen
4. Secured loans with collateral
5. Loans to financially credible borrowers, such as firms with a record of high profits
6. Loans made when the overall interest rates were relatively higher and have since fallen