Question

If you have two loans, one has annuity repayments and one repays the whole
amount at the end of the lifetime. Connect this to the principle of Expected
Losses and explain how the interest rate of these two loans should look like.

Answer 1

We will have to examine the pattern of cash flows from the perspective of the lender.

Case 1: Annuity repayment

• The lender sees some partial repayment every year
• So, the lender's exposure keep's reducing every year
• Less risky from the perspective of lender in case borrower defaults
• Expected losses will be lower as some portion of the principal would have already been repaid, in case default occurs
• Hence, this is less riskier and hence should have relatively lower interest rate

Case 2: Bullet repayment at the end of the term

• The lender doesn't get any repayment during the tenor
• So, the lender's exposure remains constant
• Higher risk from the perspective of lender in case borrower defaults
• Expected losses will be higher and may be the entire capital (principal) on default
• Hence, this is riskier and hence should have relatively higher interest rate