What is a loan?

UCL Letter #3 - March 15, 2020

Welcome to the third letter of Undirected Cyclic Thoughts. As I stated before, the goal is to bang out one letter each week. That happened well on the first week. I was day late on the second week. And, well, I’m two weeks and a day late on the third week…, Anyway, let’s get to it - let’s talk about loans.

Loans: What are they?

I thought of Ali G’s voice when I wrote that, but in all seriousness I want to take some time to jot down some notes on loans. As Silicon Valley and, more importantly, tech twitter turn their focus to all things finance (a bit ironic, I know), it’s easy for a whole new set of terminology to get injected into startup speak. Sometimes when this happens, I catch myself using terms that I don’t truly understand. This post is my attempt at laying out what a loan is and how a loan works.

Purpose of a loan

A loan is an agreement to repay a certain amount of money, generally with interest. The purpose of it is to allow you to have access to capital today, that you wouldn’t otherwise have. On the surface, it’s as simple as that.

Loans can be used for a variety of different reasons: purchasing a car or a home, paying for medical services, or buying equipment for your business. Loans can be secured (will get into this later) or unsecured. Loans can have a variety of different types of interest rates and terms. We’ll get into some of this in a bit.

How is it different from a credit card again?

The big difference between a loan and a credit card is how you borrow money and how you pay it back. With a loan, you’re generally borrowing a fixed amount of money that you repay on a fixed schedule. With a credit card, you normally have a fixed credit limit but can spend anywhere under that limit. You often also have a monthly minimum payment but are not required to pay any more. Let’s walk through an example.

Let’s say I want to buy a used Toyota Prius that costs $10,000. I may take out a loan for $8,000 because I only have $2,000 in my savings and need to cover the rest. However, if I change my mind and decide that in order to impress my friends at the country club, I really need a used Tesla Model S (which costs $30,000), I’d have to take out another loan to have enough money. That’s because loans are for a fixed amount of money, a type of debt often called installment debt.

On the repayment side of things, let’s say I get cold feet and stick with the Prius, for which I took out an $8,000 loan. That loan may be for 48 months, so I’d be on the hook for $166.67/mo to repay the loan (plus interest).

Credit cards, on the other hand, are a type of revolving debt. When you have a credit card and want to make another purchase, you don’t need to call up your bank and ask them to give you another $100. Instead, you have a credit line. A credit line is your established credit limit. As long as you stay below this amount, you can keep borrowing. As of December 2016, the average credit card limit was $8,071. That means you can spend up to $8,071 on your credit card before you start needing to pay it off.

Similarly, rather than owing a fixed amount per month, you’ll typically have some form of minimum payment. As long as you make the minimum payment, you’ve made up your end of the deal. Now, that’s not recommended as credit cards make money by charging interest on outstanding balances, but technically speaking, you’re not compelled to pay any more on a given month.

A loan’s lifecycle

Switching our focus back to loans, let’s walk through a loan’s lifecycle.

There are a lot of ways to slice and dice a loan’s lifecycle, but I find the easiest way to think about it is through these 5 steps: originating, underwriting, decisioning, funding, and servicing. You’ll hear these words tossed around a fair bit and it’s important to get on the same page with what these stages mean. For example, you’ll sometimes hear of “underwriting” as including decisioning and funding. But using this 5-step process, let’s dive into a typical workflow.

  1. Origination

Origination refers to the process from no borrower to a prospective borrower with a completed loan application.

Inputs: No borrower.

Blackbox: Typically this involves (1) some amount of marketing to attract prospective borrowers, (2) educating a prospective borrower, (3) helping a prospective borrower select the correct loan product, (4) gathering the inputs, signatures and consent in order to apply for that product. That last bit can really range in complexity. It normally entails some level of identity verification (to prevent fraud), consent and disclosure forms, and verifications of employment history, financial situation (e.g. liabilities, assets, income) and credit history.

Outputs: A completed loan application.

  1. Underwriting

Underwriting refers to the process of assessing the borrower’s ability to repay the loan based.

Inputs: A completed loan application

Blackbox: The goal of underwriting is to take a given borrower’s financial situation and to determine whether he or she is able to repay the loan. At the most elementary form, a lender may run a credit check and say “low risk” if your FICO score is 760 or higher and “high risk” if your FICO score is under 760. However, nowadays a credit score is normally one of many inputs into an underwriting model. Underwriting may also look at your bank account balances over time, your income and projected job security, and other factors. Additionally, depending on the loan product, underwriting may not just result in a binary “high risk” or “low risk”, but go so far as to suggest under what terms would borrowing be acceptable (e.g. 24 month repayment with a 10% down-payment and 15% APR).

Outputs: An understanding of the risk of lending to the borrower under certain terms.

  1. Decisioning

Decisioning refers to the process of deciding whether or not to fund a loan based on the underwriting process.

Inputs: Loan application & underwriting process

Blackbox: Now that a lender has collected all the relevant information about a person and understands the level of risk from the underwriting process, the lender needs to make a decision. If the lender wants to review further information, they can kick it back to origination. If the lender feels that the borrower is sufficiently creditworthy, they may decide to fund the loan. If the lender feels that the borrower is too risky, they may decide to reject the loan.

Outputs: Yes/No decision

  1. Funding

Funding refers to the disbursal of funds to the borrower.

Inputs: A decision to fund a loan

Blackbox: For a small lender, this can be as simple as cutting a check or wiring money. For some more complicated players, this could include syndicating the loan amount from multiple parties.

Outputs: Money disbursed to borrower

  1. Servicing

Servicing refers to all activities associated with getting the loan (plus interest) repaid to the lender.

Inputs: A completed, approved loan application with funds disbursed

Blackbox: Servicing is an entire industry in and of itself. It normally entails getting payments processed, posting statements for the borrower and the lender, providing customer support, and pursuing collections in the event that a borrower stops paying.

Outputs: Money returned to the lender

What if…?

I’m a lender and worried that someone may not pay me back?

Secured loans do exactly that! Secured refers to the fact that the loan is backed by collateral, which the borrower can repossess in the event of non-payment. The most common forms of secured loans is a mortgage, where the collateral is your house.

Someone stops making payments?

This is when you get a collections agency involved. Collections agencies normally operate on two models: (i) they charge X% of anything that is collected (often ~20%), (ii) they buy the rest of debt at a large discount (e.g. if the balance is $400, they may buy that for $200 and keep anything they collect).

Someone goes through a rough time and needs an extension?

Ah! This was very common during the Great Recession and is referred to as refinancing. You can also do this in good times, although it’s common in bad times. Refinancing refers to the process of replacing an existing loan with a new loan. That new loan will be used to pay off the existing debt completely and provide you with better terms upon which to make payments.

Lending is obviously a broad topic and you can go super deep. Origination, underwriting and servicing are industries in their own rights, with countless stakeholders, business models and innovations within them.

I hope to explore more in this space shortly, but that’s the quick and dirty overview of what a loan is and how it works.

If you’re one of the 4 active readers of this newsletter, I promise this will tie back into the last post at some point… “the arc of this newsletter is long, but may bend toward something.”