Risk Levels of Short-Term Loans - Assignment Example

1. There are many reasons why comparable short term loans have various degrees of risk. One of the primary reasons is the existence of variable term loans. A variable interest loan can change in payment on a monthly basis based on the current interest rate in the marketplace. Fixed loans are much different because these loans have a fix payment rate until maturity. A secondary reason why short term loans have different levels of risk is due to credit history of the individual or business entity. People that have excellent credit pay less than people that have bad credit. The reason people with bad credit pay more on short term loans is because they represent a high risk. A third reason why the terms of loans are different in terms of interest and risk is because each financial institution has different earnings expectations. Some banks are willing to earn less than others. 2. Granting credit to a firm or person with bad credit can result in a positive NVP. There are a lot of people that have bad credit that are not at fault. Some people lose their good credit because they co-signed for a friend or family member that defaulted on a loan. The lack of responsibility of the person that defaulted places the person in a tough situation because they are forced to pay a debt that is not theirs. Another reason why banks may earn positive NPV from people with bad credit is because they charge these individuals or business institutions a higher interest rate. 3. The credit score of a person is very influential in the terms of the credit the borrower receives. There are three credit agencies that evaluate the person. The three agencies are Equifax, TransUnion, and Experian. You are correct in your assumption that the amount of credit experience a person has influences the credit score of the individual. The three credit agencies utilize different criteria to evaluate the person. My father recently applied for a loan and he was denied because one of the agencies rated him as a 560. It was strange that another one of the agencies gave him a 716 score. 4. I have always preferred to have a variable interest loan than a fixed interest loan especially in long term loans. The market fluctuates a lot and a variable interest loan can enable a person to negotiate better terms of credit if the market conditions become favorable. Some people on the other hand prefer fixed loans because of the security of knowing the exact amount you have to pay on a monthly basis. When the interest rate goes down it is better to have a flexible interest loan, but when it goes up the fixed payment loan is the best alternative. 5. The types of financial institutions that deal in very short term loans such as 15 to 30 loans have a lot of business because everyone every so often faces an emergency that requires instant cash. People also on many occasions are not able to keep up with the budget and the run out of cash. You need cash for daily food expenses and transportation cost to go to work. Due to the risk involved in these types of loans it is justified for these firms to charge a high interest rate. Also these firms have to charge a high interest rate because they do not enjoy the benefits of compound interest like other banks due to the fact that the debt is settled in a very short term. Banks make a lot of interest money during the first part of a long term loan. Shorter loans generate less interest revenues. 6. It is true that when people are faced with an emergency that requires instant cash they do not care about the terms of the agreement. In our world there are people that take advantage of the necessities of the poor by becoming loan sharks. Loan sharks are people that create an illegal lending operation which charges on my occasions upwards of 10% per week. People borrow money from these loan sharks when they have nowhere else to turn. Short term lending institutions that deal 15 day and 30 day loans are the legal equivalency of a loan shark. They charge 30% to 50% yearly interest on short term loans. 7. The credit score of a person or business institution greatly affects the interest rate the borrower receives. The amount of time or total overall credit history a person has also influences a lot on the interest rate a person receives. When I applied for my first credit card I saw an offer of 7.95% interest being offered by the bank for new credit card holders. I filled out the application and when the bank processed it they denied me the card at the 7.95% interest. The bank claimed that my lack of credit history was hurting my application. I got approved for a Visa credit card at 19.99% interest. 8. You are correct in your asseveration that people with bad credit can represent a solid customer that can bring a financial institution a lot of money. The reason the bank can obtain positive NPV from these types of clients is because they charge them more money in terms of interest rates. As you mentioned there are a lot of variables that influenced the NPV of a loan. Banks are able to charge higher interest rates on short term financial instruments such as credit cards than in long term mortgage loans. 9. I disagree with your opinion that short term debt instruments have lower risk than in long term loans. The reason I disagree is because the banking industry charges higher interest rates on short term debt instruments such as credit cards than on long term instruments like mortgages. If you evaluate the interest rate on your credit cards you will noticed that it is much higher than on your mortgage. Interest rates are higher when there is a bigger risk involved. Read More