OK, Back To The Basics of Lending
Now is not really a great time for FUNDAMENTALS. Things like ‘facts and substance’ are often viewed as getting in the way of vision, creativity and growth. But guess what? Knowing what you are doing is still ‘en vogue’.
At LoanCirrus we support lenders around the world and we sometimes help them to set up LoanCirrus to their specifications, we hear a very wide range of questions from our customers. We realized that many of our customers (and we imagine others) may need a little refresher on the basics of lending. So here we go…
THE BASIC BASICS
Loans are debt. Someone takes a loan you are in a creditor/debtor relationship with them. You extend credit (Creditor) and the assume a debt (Debtor).
Loans are ASSETS to you and LIABILITIES to your BORROWER.
The Cash you loan is called PRINCIPAL
The price you charge for the money you loan is called the INTEREST
It is typical that you get repaid the money you loan PLUS the Interest you have charged for that money.
THE (not so) BASICS
Simple Interest is the most basic form of Interest . Not all Interest is calculated this way.
Simple Interest is when you charge the interest ONCE during the term. NO COMPOUNDING occurs. An example, You loan 100,000 @ 10% per month for 10 months. Clearly the Interest here is simple: 100,000 X 10% x 10 = 10,000 You will pay 10,000 interest for this loan for the 10 months. I can split it into 10 payments, 5 payments or 2 payments – it doesn’t matter the frequency of repayment, it is still 10,000 that I repay in interest.
To account for all other types of interest calculation periods a compounding effect is required. So, If Interest is to be charged WEEKLY instead of once, then we need to figure out how much of the interest is to be charged each week. For that we simply take the monthly interest and divide by 4 (4 weeks in a month). Then take the weekly rate and charge it weekly then compound it for the term. While the interest rate remains 10% per month, you will get a higher interest amount when the total annual interest is summed. This new amount when fractioned will provide the Annual Percentage Yield (APY).
Fees are NOT a requirement of lending. If you learn how to calculate and set a proper price (interest rate) then you should not need to charge customers a fee to have a loan processed and God forbid you would charge someone simply to apply for a loan. In many instances, fees are simply upfront interest payments although they are not presented this way to customers.
Penalties are also NOT a requirement of lending. In fact, there are other schools of thought suggesting that penalties are counterproductive to building healthy customer relationships and therefore portfolios.
Over reliance on either fees or penalties for break even suggest an underlying portfolio problem and this will require deep analysis.
The Interest you charge for the money you lend is considered Interest Income for your business. While your business can have some amount of ‘other income’ interest income should be your PRIMARY source of revenue.
From your Interest Income you are expected to cover your cost of capital and operating expenses. If something is left over you must pump it back into lending to organically offset revenue churn from delinquent borrowers.
It doesn’t matter what interest rate you charge, only who you target. Like every other market on earth, lending is a spectrum. There are customers all along that spectrum. Ensuring proper fit between your rates (price) and your market is more important an abstract and absolute view of price.
Lending is commodified – it’s been around so long and the only real barrier to entry is…well, money itself.