What Is a Lender?
Lenders are people or companies that allow you to borrow money with the promise that it will be repaid. Repayment includes principal and interest, and may include monthly payments or a lump sum payment. Loan terms are the specifics of the loan, such as interest rate, payment amount, length of the loan, consequences of default, and other details.
Types of Lenders
Lenders provide loans for various reasons, such as mortgages and auto loans. Lenders may also offer lines of credit, home equity loans, small business loans, and credit cards, among others. Most lenders are banks or financial institutions, but there’s no rule that says only banks can be lenders. A lender can be a financial institution, private company, or even an individual. Most loans are documented with some sort of loan agreement, such as a note, which defines the repayment terms.
Peer-to-peer (P2P) lenders are individuals that lend money to other individuals via peer-to-peer networks, such as LendingClub. There are lenders that specialize in student loans, notably Sallie Mae. The U.S. government is also a lender in some cases, offering Perkins and Stafford loans for educational expenses. The Federal Reserve makes various loans, including those to commercial banks that need to meet reserve requirements. Stores, such as those that offer furniture and appliances, offer loans when purchasing items, but these loans are usually facilitated by third-party financing institutions.
Hard Money Lenders
Hard money lenders are part of a special subset of lenders within the real estate market. Loans from hard money lenders are generally short-term (one to five years) and used by real estate investors. Hard money lenders use the property as collateral, relying less on the merits (credit worthiness) of the borrower. There lenders are usually individuals or investors.
The benefit of these loans is that they can happen fast. The lender is more interested in the property or collateral and less about the borrower’s credit score and collecting personal financial information. These loans also offer more flexibility, notably with repayment schedules. Hard money lenders tend to try and keep loan-to-value ratios somewhat low, such as between 50% and 70%.
These hard money lenders are best utilized by real estate investors who can return the money relatively quickly, such as fix-and-flip investors. These types of investors buy a property and look to quickly increase the value before selling it.
Types of Loans
There are a variety of loans that go beyond just a personal loan or a business loan. There are conventional loans, which are mostly attributed to mortgages. These types of loans are from lenders and banks that are not backed by government agencies. Now, conventional loans can be conforming or non-conforming. Conforming loans meet Freddie Mac or Fannie Mae guidelines, with the most notable guideline being a maximum loan amount. An example of a non-conforming loan is a jumbo loan.
Meanwhile, some loans are secured by assets, also known as collateralized or secured loans. Upon default, the personal property is transferred to the lender. Types of secured loans are mortgages and auto loans. Unsecured loans are not backed by collateral.
Open-ended loans can be borrowed from again and again as they are repaid. Examples of these include credit cards and home equity lines of credit (HELOC). Meanwhile, closed-end loans, such as car and student loans, cannot be borrowed from again.
To get a loan, a lender looks for a solid credit history, which includes assessing the borrowers credit report and ability to repay the debt. Most lenders will check the borrower’s debt-to-income (DTI) ratio, which calculates an individual or company’s debt as a percentage of pre-tax income.
For example, if an individual makes $5,000 in gross income per month and their payments (mortgage, auto loans, credit card payments, etc.) total $2,000, their debt-to-income ratio is 40%. Most lenders will balk at a debt-to-income ratio above 43%, with an ideal ratio coming in below 36%.
Lenders and Credit Scores
A credit score is a number ranging from 300 to 850 that lenders use to determine the creditworthiness of borrowers. Credit bureaus—Experian, Transunion and Equifax—are the ones that assign credit scores. These scores are based on the individual’s credit history, which includes payment history on loans and credit cards and the average age and balance of accounts.
The weighting of each category varies, i.e. your payment history is the highest weighted, while the amount of new credit you’ve obtained and the type of debt you have are weighted the least. Lenders will generally only pull your credit report and score from one of the three credit bureaus. The credit score—the higher, the better—is a quick and easy way for a lender to determine your creditworthiness. A credit score will also affect the interest rate you pay, where a higher score means you’ll qualify for a better (lower) rate.
Lenders and Interest Rates
Lenders charge interest for lending money. This is a cost for the borrower, but it’s the rate of return for the lender. They may also charge fees, such as origination fees and closing fees. Interest rates will vary based on the credit quality of the borrower, as well as what the money's for, i.e. whether it’s collateralized, and if so, with what. Higher risk loans tend to carry higher interest rates. Home loans, also known as mortgages, have some of the lowest interest rates because they are backed by an asset—the home—that can’t be moved, can’t be hidden, and has a relatively stable value.
Car loans have slightly higher rates than mortgages because, although they are backed by the value of the car, this asset can be a bit harder to repossess. Unsecured loans, which have no asset backing, charge even higher interest rates. However, rates on credit cards tend to be higher yet, while rates on payday loans tend to be the highest in the industry.
Interest rates are determined not only by the borrower’s credit, but also by market factors, such as the strength of the economy and the Federal Reserve’s monetary policy. The difference in an interest rate can amount to a lot of money for the borrower. Let’s say a borrower is looking for a 30-year fixed mortgage for $500,000. The difference between 3.5% and 4.5% on that loan is over $100,000 in interest.
For more information on lenders and loans, be sure to read our Ultimate Beginners Guide to Home Loans.