A loan involves letting a borrower use a specific amount of resources for a specific period of time. In return, the borrower must pay the lender a series of payments over a predetermined period of time, which is equal to the principal loan amount plus a predetermined interest rate.
To create a successful business that offers value through a loan, you need to:
- Have money to lend.
- Find people who want to borrow that money.
- Determine an interest rate that compensates you fairly for the loan.
- Estimate and protect yourself against the possibility that the loan won’t be repaid.
When used responsibly, loans allow people to benefit from immediate use of products and services that would otherwise cost too much to buy directly. For instance, mortgage loans allow people to live in houses without having hundreds of thousands of dollars in their bank account. Similarly, auto loans allow people to drive new vehicles in exchange for a smaller monthly payment rather than a 100% down payment.
Loans are valuable to the lender because they provide a way to benefit from extra capital. With the addition of compound interest on top of the principal loan amount, the lender will collect a lot more than the original loan – and in the case of long-term loans such as mortgages, possibly two to three times more. For instance, on a $250,000 mortgage loan with a 30-year term and a 5% interest rate, the lender will receive over $230,000 in interest payments on top of the original $250,000 loan amount.
After the loan is made, there’s not much more additional work that the lender needs to do other than collect the payments. But since there’s a chance that the borrower will stop making payments, it’s important to identify the level of risk with a specific loan prior to lending any money. This is done through a process called underwriting.
During the underwriting process, lenders often require some sort of asset from the borrower as collateral to protect against the possibility that the loan won’t be repaid. If the loan is not repaid, ownership of the collateral is transferred to the lender, who sells the asset to recover any money lost in the deal.
To learn more about loans as a form of value, check out The Personal MBA by Josh Kaufman.
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