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Lending Basics

What is a loan?

A loan is a debt of one party to another. Party A provides a sum of money X to the borrowing party B in exchange for future repayment of an amount (normally) greater than X.
The difference between the amount borrowed (X) and the amount repaid (let's say Y) represents a rental fee on money. It's the cost of money basically.
The total amount repaid (let's say Z and Z = X+Y) represents the principal amount borrowed plus the cost to borrow.
The cost to borrow (Y) is often repaid in a stream of payments by the borrower to the lender. These payments are known as interest payments and interest, or rather the interest rate, represents the cost of money.

Below are two common types of lending:

  1. 1.
    Secured Debt: A loan is considered ‘secured’ if the borrowed money is backed by collateral. Collateral is an asset containing a level of resellable value which is given to the lender in the event of the borrower’s inability to service a loan or its interest payments. Putting up collateral for borrowed money reduces the risk of loss for the lender. Car loans are a secured debt agreement for example. Failure to meet agreed-upon principal + interest payments would result in the car being taken away from the borrower and being resold by the lender.
  2. 2.
    Revolving Lines of Credit: Loans can vary by the frequency in which a borrower can access money. Receiving the one-time principal amount up-front is considered a ‘term’ loan. On the other hand, a ‘revolving’ loan allows a borrower to receive money whenever they need to – until they reach a pre-determined limit. Bank lending facilities such as those used for a Credit Card or overdraft are forms of Revolving Lines of Credit. Borrowers are afforded the flexibility on the amount and frequency of using credit and at the end of the month typically they pay the principal balance + interest due.

How interest payments are determined and why this rate varies by loan type and prospective borrower:

Again, interest is the amount a creditor (lender) charges a borrower for the use of money. From the borrower’s perspective, interest is the cost of borrowing. The interest rate charged is a percentage of the loan amount and this differs depending on several factors touched on below.
The interest rate required for a loan is determined by the level of risk associated with the borrower’s ability to repay the principal loan amount. A low-risk borrower possesses the ability to consistently generate a surplus of cash (cash net of existing obligations) – think of an individual with a steady, high-paying job accumulating disposable income and having a strong record of meeting prior debt obligations. Low-risk borrowers receive lower interest rates because lenders feel confident that advanced money or assets will be repaid in full. In light of this, high-risk borrowers offer the risk-tolerant lender more attractive interest payments for use of their money. The lender may be inclined to accept the heightened risk if they believe that the borrower’s financial circumstances or future ability to repay will improve having received the loan. An example would be a modestly performing business receiving a loan to build a factory in order to produce and sell more products. There is uncertainty risk associated with lending money to build a factory that has yet to produce and sell a single good, let alone enough to meet regular interest payments in addition to the principle.
Before extending capital to the business, the lender must analyse the loan and the borrower.
The lender's analysis will include but not be limited to the following:
  1. 1.
    The length and type of loan
  2. 2.
    Whether a loan is secured or unsecured (not backed by collateral)
  3. 3.
    How the funds will be used and how that impacts upon the 'as is' state of the business
  4. 4.
    The level of interest that similarly riskier borrowers are willing to accept in the broader loan market
  5. 5.
    Provisions or guarantees assured to the lender in the event that a Borrower cannot repay.