Question

Explain Default or Penal interest as a factor affecting market rate of interest.

Hint:

Remember: More defaults mean more risk, which often raises the general market rate of interest.

Answer 1

Default or Penal Interest is an extra rate of interest charged by banks or lenders when a borrower fails to pay installments or dues on time.
When borrowers delay payments, banks impose a penalty to discourage defaults and compensate for the risk and inconvenience.
This penal interest increases the effective cost of borrowing for the defaulter.
In the larger market, high levels of default risk push banks to keep market interest rates higher to cover possible losses.
Therefore, the risk of default and the resulting penal interest directly influence the market rate of interest.