Structuring Agreements for Profitable Outcomes
Risk is inherent in lending money. Creative risk mitigation can help to ensure profitable outcomes. Smart lenders design their loan agreements to ensure profitability in the face of excellent and terrible borrowers alike. The interest rate and term of the loan is just the tip of the iceberg for a well designed, profitable agreement.
I chose this topic for an article after rereading the marketplace performance statistics at Prosper.com. Even beyond my skepticism about their reports and the mathematical correctness of the figures, the outcomes are dismal. Only the most well qualified borrowers yield a return over the lifetime of the loan – and them at a whopping 4%. The overwhelming majority of loans end in a net loss.
Meanwhile, the hundreds of lenders I've talked to are reaping consistent returns – from modest to staggering. One of the main differences between lenders using my Moneylender Professional software and lenders on Prosper.com is that professional lenders carefully engineer their deals to maximize profitable outcomes.
Profit opportunities can be built into the agreement to offset loan underperformance. Common among users of Moneylender Professional, several tactics allow smoothing out less-than-optimal repayment:
Late fees and collections fees – Lenders can customize the fee structure to penalize late payments to the point that, aside from total loss, an overall profit is recovered when a loan becomes delinquent. In addition to the standard late fee, additional fees are assessed for collections calls, collections letters, and visits to the borrower’s residence. Fees that offset activities are added if the accounts become sufficiently delinquent to merit legal action, fees which must be repaid to reinstate the loan.
Seizure and repossession of collateral – Very common in the automotive and mortgage lending industry, and popular with personal loans, is securing the loan against one or more assets. If the loan underperforms, the asset can be used to offset the unpaid balance. For lenders with their fingers in multiple businesses, acquiring and reselling an asset multiple times leads to higher profitability than if the loan performed as agreed. Underperformance is designed to be more profitable than performance. That’s a smart way to turn risk into a cash factory*.
Secondary borrowers – If the borrower doesn't pay the loan, having a second borrower on the line to ensure timely payment is a great tool for sustaining the profitability of each investment. Underperformance by a less qualified borrower becomes the interpersonal burden of friends or relatives who were willing to accept that burden when the loan was made. Cash flow is only interrupted long enough for the lender to exercise the option of the secondary borrower and then repayment resumes, and fees typically recover the cost of the interruption.
Default rates – When a payment is late or missed one or more times, it is common that the loan changes to a higher interest rate. Usually this rate is temporary and might last for three months to a year after payments resume timely arrival. Adding default rates to an agreement allows lenders to recover the expense of an interruption to cash flow.
There are always ways to ensure profitability for the creative lender. In each type of business, there is something unique that can be leveraged to reduce or offset the cost of underperforming loans. Assess your situation and your borrower’s situation and look for ways that a loan might fail and what can be done to ensure profitability in those cases. With a little practice, savvy lenders can engineer their agreements for consistent profit with little risk of loss of capital.
These may seem like ugly options. We’re talking about borrowers that overestimate themselves and leverage too much. For anyone trying to succeed as a lender, be it for a business, retirement, or other reasons, they have an obligation to ensure they don’t shackle themselves with the burden brought to them by their borrowers. Lenders should not be the unwittingly charitable financiers of other peoples’ wants or ventures and it’s important that they protect themselves from becoming so.
On the flip side, you may be able to offer well performing borrowers with special benefits which they appreciate while adding to your profit. Well performing borrowers have demonstrated their creditworthiness, so it makes sense that a good lender would offer credit to such a person.
Skip a payment and “add it to the end of the loan” – The holiday season is a great opportunity to increase profit in a way that borrowers appreciate. Allowing a borrower to skip the payment for December or January in exchange for a new payment amount which corrects for the accrued interest is a great way to make a mutually beneficial profit on an existing, well-performing loan.
Loans are a fascinating investment, and they’re becoming increasingly popular. By thinking on your feet and lending money under agreements that maximize the likelihood of a profitable outcome, you can grow your portfolio and ensure the productivity of your invested capital.
* I am personally against exploitative lending practices. I've learned to have discipline by buying and losing several things at great personal expense. The experience of financial struggle and loss has taught me to temper my purchasing behaviors. I was a qualified borrower who underperformed and was subject to many of the measures I describe above, and I only had myself to blame. I've seen it from both sides. Caveat emptor – consumers are responsible for knowing what they can afford; it’s not the lenders job to decide if the buyer is making a good decision. When I wanted a car and presented evidence to the lender that I could repay the loan, it is hardly the lender’s fault when my naiveté in business led to total insolubility. It was a relief when I surrendered the car; having that repossession clause in the loan led to a win-win outcome.
I chose this topic for an article after rereading the marketplace performance statistics at Prosper.com. Even beyond my skepticism about their reports and the mathematical correctness of the figures, the outcomes are dismal. Only the most well qualified borrowers yield a return over the lifetime of the loan – and them at a whopping 4%. The overwhelming majority of loans end in a net loss.
Meanwhile, the hundreds of lenders I've talked to are reaping consistent returns – from modest to staggering. One of the main differences between lenders using my Moneylender Professional software and lenders on Prosper.com is that professional lenders carefully engineer their deals to maximize profitable outcomes.
Profit opportunities can be built into the agreement to offset loan underperformance. Common among users of Moneylender Professional, several tactics allow smoothing out less-than-optimal repayment:
Late fees and collections fees – Lenders can customize the fee structure to penalize late payments to the point that, aside from total loss, an overall profit is recovered when a loan becomes delinquent. In addition to the standard late fee, additional fees are assessed for collections calls, collections letters, and visits to the borrower’s residence. Fees that offset activities are added if the accounts become sufficiently delinquent to merit legal action, fees which must be repaid to reinstate the loan.
Seizure and repossession of collateral – Very common in the automotive and mortgage lending industry, and popular with personal loans, is securing the loan against one or more assets. If the loan underperforms, the asset can be used to offset the unpaid balance. For lenders with their fingers in multiple businesses, acquiring and reselling an asset multiple times leads to higher profitability than if the loan performed as agreed. Underperformance is designed to be more profitable than performance. That’s a smart way to turn risk into a cash factory*.
Secondary borrowers – If the borrower doesn't pay the loan, having a second borrower on the line to ensure timely payment is a great tool for sustaining the profitability of each investment. Underperformance by a less qualified borrower becomes the interpersonal burden of friends or relatives who were willing to accept that burden when the loan was made. Cash flow is only interrupted long enough for the lender to exercise the option of the secondary borrower and then repayment resumes, and fees typically recover the cost of the interruption.
Default rates – When a payment is late or missed one or more times, it is common that the loan changes to a higher interest rate. Usually this rate is temporary and might last for three months to a year after payments resume timely arrival. Adding default rates to an agreement allows lenders to recover the expense of an interruption to cash flow.
There are always ways to ensure profitability for the creative lender. In each type of business, there is something unique that can be leveraged to reduce or offset the cost of underperforming loans. Assess your situation and your borrower’s situation and look for ways that a loan might fail and what can be done to ensure profitability in those cases. With a little practice, savvy lenders can engineer their agreements for consistent profit with little risk of loss of capital.
These may seem like ugly options. We’re talking about borrowers that overestimate themselves and leverage too much. For anyone trying to succeed as a lender, be it for a business, retirement, or other reasons, they have an obligation to ensure they don’t shackle themselves with the burden brought to them by their borrowers. Lenders should not be the unwittingly charitable financiers of other peoples’ wants or ventures and it’s important that they protect themselves from becoming so.
On the flip side, you may be able to offer well performing borrowers with special benefits which they appreciate while adding to your profit. Well performing borrowers have demonstrated their creditworthiness, so it makes sense that a good lender would offer credit to such a person.
Skip a payment and “add it to the end of the loan” – The holiday season is a great opportunity to increase profit in a way that borrowers appreciate. Allowing a borrower to skip the payment for December or January in exchange for a new payment amount which corrects for the accrued interest is a great way to make a mutually beneficial profit on an existing, well-performing loan.
Loans are a fascinating investment, and they’re becoming increasingly popular. By thinking on your feet and lending money under agreements that maximize the likelihood of a profitable outcome, you can grow your portfolio and ensure the productivity of your invested capital.
* I am personally against exploitative lending practices. I've learned to have discipline by buying and losing several things at great personal expense. The experience of financial struggle and loss has taught me to temper my purchasing behaviors. I was a qualified borrower who underperformed and was subject to many of the measures I describe above, and I only had myself to blame. I've seen it from both sides. Caveat emptor – consumers are responsible for knowing what they can afford; it’s not the lenders job to decide if the buyer is making a good decision. When I wanted a car and presented evidence to the lender that I could repay the loan, it is hardly the lender’s fault when my naiveté in business led to total insolubility. It was a relief when I surrendered the car; having that repossession clause in the loan led to a win-win outcome.
posted by Josh Whitman at
July 26, 2013
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