Internal Funding vs. Bank Backing vs. Investor Backing

Of all the lenders I’ve talked to who use my loan servicing software (Moneylender Professional), there are three underlying financial structures they typically use for lending money.  I’ve personally done a few loans that were internally financed and a couple that were investor financed.  There are advantages and disadvantages to each.

Internally Funded Lending

The simplest system for a lender is to loan money that the lender has on hand.  “I have $10,000 in my bank account, I’ll give it to you and you pay it back with interest.”  The main advantage is that you can control everything.  There’s no one to be accountable to except yourself (and the government, of course).

If the borrower defaults, files bankruptcy or just refuses to pay you may be forced to write off the loan as an uncollectable debt.  The money you loaned out is off earning you interest and as it trickles back in, you’ll be able to make new loans with the principal and interest but it’s going to take a while.  You accept the full risk of the loan and your funds are tied up for the life of the loan.

Bank Backed Lending

If your meticulous accounting can afford you the good graces of a bank with cash to invest, you might be able to set up a master loan at a lower interest rate and pay this money out in smaller loans at a higher interest rate.  For many businesses with a track record of reliability and financial health, especially ones that sell an expensive product, this is a viable option. 

As an example, a bank will set up a revolving line of credit you can use to pay yourself when someone buys your goods.  In turn, the customer takes out a loan from you which you use to repay the bank.  You make one payment to the bank at a fixed interest rate and receive several payments from borrowers which include the bank payment and a tidy profit for you to keep for yourself.

The huge advantage is that you can grow your loan portfolio very quickly, and banks typically have relatively massive lending power that you can tap into.  In conjunction with a business, this can mean a major increase to overall profitability as sales also increase because of the available funding.  Little cash on hand is required to make new loans because the bank often covers the full principal disbursal.  With bank backing and well qualified borrowers sufficiently available, a seven figure portfolio is right around the corner.

If a loan goes bad and is irrecoverable, hopefully the other loans will still cover the cost of the payment to the bank.  You’ll be completely on the hook for any debts that go bad, and ultimately, you are the one who borrowed the money from the bank and have to ensure it gets repaid.  Banks typically require frequent, detailed updates on the heath of your portfolios.  You may be reprimanded or have your available funding reduced if the bank is unhappy with your portfolio’s performance.  Banks are often less flexible with the structure of the loans, so you’ll usually be making standard fixed-term loans to your customers.  You’ll be blessed with rapid growth, but cursed with liability and leverage when things don’t go perfectly.

Investor Backed Lending

This is perhaps the most common among users of Moneylender Professional. Finding investors willing to purchase your loans might prove to be a challenge, but if you can do it, you’ll have access to lendable capital while offloading the liability of loan performance onto someone else. 

A loan can be made to a borrower with funds on hand.  The loan is then sold, either at full price or a discount to an investor.  If you loaned $10,000 at 15% and then sold the loan for $10,000 at 10%, you’ll be able to service the loan, making 5% on the balance without any actual cash out of pocket.  The investor’s $10,000 for the purchase of the loan is immediately available to lend again.  Also, if the loan goes bad, the investor is saddled with the risk instead of you.

Essentially, you’ve become a loan servicer – collecting 5% interest on a balance that’s not your money anymore.  You originate loans and service them, but the risk falls to the investors that own the individual loans.  Obviously, no savvy investor would just throw their money away, so most of the people I know that do this sort of origination/servicing/resale business have engineered the loans for multiple profitable outcomes that benefit both lender and investor.

To sum it up:

Internal Financing

• Slow growth
• Full liability for each loan
• Total control

Bank Backing

• Rapid growth
• Overall liability for portfolio performance
• Careful scrutiny
• Limits on how loans can be structured

Investor Backing

• Rapid growth
• Minimal leverage / liability if a loan fails
• Moderate oversight usually required
• Flexibility in business structure for greater profitability