Lending

Lending is the act of providing money, property, or other material goods to another party in exchange for future repayment of the principal amount, along with interest or other finance charges. For an investor, lending isn't just about helping out a friend or getting a mortgage; it's a fundamental form of investment. When you buy a corporate bond, you are lending money to that company. When you deposit cash into a savings account, you are lending money to the bank. In essence, you are playing the role of the banker, putting your capital to work in exchange for a promised return. The core challenge, and the art of successful lending, lies in accurately judging the borrower's ability and willingness to pay you back. A misjudgment can lead to a partial or total loss of your initial investment. Therefore, a smart investor approaches lending with the same diligence as buying a piece of a business, always focusing on safety first and then seeking an adequate, predictable return. It's one of the two primary ways to invest, the other being owning a piece of a business (equity).

Many activities that investors engage in are, at their heart, forms of lending. You are temporarily entrusting your money to an entity—be it a government, a corporation, or a bank—with the legal expectation of getting it back with a little extra for your trouble. This “little extra” is your investment return.

While the concept is simple, the methods can vary. Here are a few common ways an ordinary investor acts as a lender:

• Bonds: This is the most direct form of lending for most investors. When you purchase a bond, you are lending money to its issuer (a government or a company). In return, the issuer promises to make periodic interest payments, known as the coupon, and to return the principal amount on a specific maturity date. Your safety depends entirely on the financial health of the issuer.
• Bank Deposits and Certificates of Deposit (CDs): It might not feel like it, but every time you put money in a savings account or a CD, you are making a loan to the bank. The bank then pools these deposits and lends them out to other customers for mortgages and business loans at a higher interest rate. Your interest payment is your small slice of the bank's profit. This is generally a very low-risk form of lending due to government deposit insurance schemes.
• Peer-to-Peer (P2P) Lending: A more modern and direct approach, peer-to-peer lending platforms allow you to lend money directly to individuals or small businesses, cutting out the bank as a middleman. While this can offer potentially higher returns, it also comes with significantly higher credit risk, as the borrowers are typically not as financially secure as large corporations or governments.

Successful lending isn't about finding the highest interest rate; it's about ensuring you get paid back. A 15% return is worthless if the borrower defaults and you lose your entire principal. This is where a value investing mindset is crucial.

Before lending a dime, you must analyze the borrower's ability to repay the debt. This involves asking critical questions:

• Does the borrower have stable and sufficient income to cover the interest payments?
• Do they have a strong balance sheet with more assets than liabilities?
• What is their track record of repaying past debts?

This process is the bedrock of managing credit risk. A wise lender always seeks a margin of safety. For example, you might only lend to companies whose earnings are at least five times their interest expenses, providing a thick cushion in case business sours.

The interest rate is the price you charge for two things: risk and time.

1. Risk: The shakier the borrower, the higher the interest rate you should demand as compensation for the increased risk of default.
2. Time: You are also being compensated for giving up the use of your money for a period, a concept known as the time value of money.

General interest rate levels are heavily influenced by central banks like the U.S. Federal Reserve or the European Central Bank. When they raise rates, the return on all forms of lending tends to go up, and vice-versa.

The legendary investor Benjamin Graham taught that there is no such thing as a “safe” investment, only a safe price. This applies perfectly to lending. A bond from a blue-chip company can be a terrible investment if you overpay for it, while a loan to a less-known entity can be wonderful if the interest rate generously compensates you for the well-understood risks. Treat lending as you would any other business decision. Analyze the borrower with a critical eye, demand a margin of safety, and ensure the price—the interest rate—makes the venture worthwhile. Your primary goal is not to chase high yields, but to ensure the return of your capital before you worry about the return on your capital.