If you had to define lending, above and beyond describing it as one party loaning money to another, what would your definition be? Many people understand lending as a service provided by banks, credit unions, and private lenders. That it is. But lending is also a business.
Understanding the business side of lending sheds light on why lenders do what they do. They are not in the business solely for the pleasure of helping people reach their financial goals. That’s the way it is in a free market economy.
Different Types of Lenders
Actium Partners, a hard money lender based in Salt Lake City, Utah, says that the financial services sector offers different types of lenders to meet different financial needs. For example, hard money lending is primarily designed to meet the needs of property investors, small businesses, and other commercial borrowers.
In addition to hard money lenders, others include:
- retail banks and credit unions
- commercial banks
- private mortgage lenders
- private business lenders
- government-backed lenders.
Nearly every lender specializes in one or two areas. Actium Partners’ specialties are real estate investments and business expansion. Your local bank probably specializes in mortgages and personal loans. Meanwhile, a private mortgage lender down the block might only do residential mortgages.
Profiting Through Rates and Terms
As a service, lending generates revenues through the combination of rates and terms. We are all familiar with interest rates as a percentage of the total amount borrowed, amortized over time. Most of us know enough to look at rates when comparing similar loans. But what about terms?
Terms dictate how long a borrower will pay on the loan. What many people do not know is that longer terms result in higher total interest payments. Why? Because the longer a loan has an outstanding balance, the longer the lender can charge interest on that balance.
This is why financial experts encourage making extra principal payments when possible. Knocking down the principal reduces the amount of money the lender can charge interest on. It also shortens the term, ultimately reducing total interest payments by also reducing the amount of time to fully repay.
Profiting Through Fees and Charges
Lenders also assess a variety of fees and charges designed to cover their costs of doing business. But do not believe for a minute that they only charge enough to break even. A typical lender charges over and above real costs as a means of generating additional profit for the services provided.
A retail bank may pay a local appraiser several hundred dollars to appraise a home before approving a mortgage. It wouldn’t be unusual for the bank to turn around and mark up the appraiser’s fee when passing it along to the borrower. And that’s just one example.
Lenders Have Their Margins
Like any other business, lending involves establishing satisfactory margins. A margin is that percentage of the company’s revenues that constitute profit. For example, if a company’s total revenues were $1 million compared to operating expenses of $750K, its $250K profit would equal a margin of 25%.
Margins are critical to lenders in the sense that these determine how worthwhile a particular loan is. If the margin isn’t high enough, justifying the risk may not be easy. Loan denial would be the likely result.
It is not unusual for some people to begrudge lenders for making so much money off them. What they do not realize is that lending is as much a business as it is a service. Businesses exist to make money. That’s just the way it is.