The interest charged on loans is determined by the __________?

1. Analyze the question The question asks what determines the interest charged on loans. Interest is the price of borrowing money, so we need the factor that directly shapes that price.

2. Explain the concept Interest rates on loans are mainly set by:

• The cost of funds, such as the Central Bank's Monetary Policy Rate (MPR).
• Risk: the higher the chance the borrower will default, the more interest the lender demands as compensation. This is called the risk premium.
• Demand and supply of loanable funds.
• Loan duration, since longer loans generally carry more uncertainty.
• Inflation expectations.

Lenders such as banks charge more for riskier borrowers. For example, a new business with no collateral pays a higher rate than a well-established company with strong security.

3. Evaluate the options

• A. Exchange rate: This is the price of one currency in terms of another. It affects trade and import costs, but it does not directly set the interest on a loan.
• B. Fiscal policy: This is government spending and taxation. It can influence the economy broadly, but it does not set the rate on an individual loan.
• C. Risk associated with the loan: This is correct. The greater the risk of default, the higher the interest rate charged.
• D. Rate of production in the country: This is about national output. It is not a direct determinant of loan interest.

4. Answer The correct option is C. Risk associated with the loan.

5. Exam tip Remember the phrase "Higher risk, higher rate." When a JAMB question asks what determines the price of credit, look for the option that mentions risk, the demand and supply of loanable funds, or the monetary policy rate. Options about exchange rates, fiscal policy, or production are usually distractors.