Suppose you go to a bank, intending to put your savings into the term deposit paying annual interest rate from 14% to 15% with your savings. Explain why you would not offer a loan to the next individual who applies for a car loan at your local bank at a higher interest rate e.g. 17% to 18% than the bank pays on the term deposit (but lower than the rate the bank charges for car loans e.g. from 20% to 22%). Consider the transaction cost you can avoid by putting your savings into the term deposit.

In this case we have two options:-

1) Deposit the money in banks as term deposit and generate a risk free return of 14-15% p.a. on the deposit.

2) Lend the money to the individual seeking car loan at a higher rate of 17-18% but at a credit risk.

As we can see one investment is risk free i.e. it is safe and we can expect assured return while on the other hand although we are getting a bit higher return but we are exposing ourselves to credit risk and we may even loose our investment in case the individual defaults. Not to mention the transaction cost that is involved in lending the loan to the individual which can be quiet high. Even if the person is offering collateral to us then also to recover the investment along with the interest we might need to incur transaction costs in case the borrower defaults. In worst case scenario we might also need to incur legal charges in case the matter goes to court in case of default. So including these factors under consideration we can conclude that it is best to invest in bank as term deposit rather then lending to the individual.