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Use the theory of preferences to explain why banks charge higher interest rates on loans with...

Use the theory of preferences to explain why banks charge higher interest rates on loans with longer terms

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According to the liquidity preference theory, lenders generally wants to get compensated for the money they lend as lending of money deferred their usage of loaned amount.

This theory also states that as maturity of loan increases, risk associated with default also increases.

This increase in risk of default induces lenders to charge higher interest rate so as to be compensated for higher risk associated with money lent for longer period.

So, when banks make loans with longer terms, their risk of default also increases and due to this (as stated by the liquidity preference theory) they charge higher interest rates on loans with longer terms.

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