Note to my readers: The articles on Alex Trueba’s account aim to help you understand various aspects of finance for better decision-making, and, more often than not, simplicity requires leaving details behind. The goal is to understand concepts, not to make a masterclass in economics or finance. The examples use simple numbers and don’t reflect current market data because the aim is to be practical, global, and as evergreen as possible.
Building on our last article, reference and benchmark rates form the basis for pricing financial markets, including government and corporate debt, which, at their core, represent market loans. As eager as I am to write about financial instruments and capital markets, let’s start with the basics of loans.
By now, we can all agree that a loan is an agreement between borrowers (the party seeking money) and lenders (those with excess liquidity who can provide it); both represent the transactional parties, usually known in the industry as the counterparties.
In banking, two or more banks may participate in a corporate loan through club deals, syndications, and other mechanisms. The goal here is to share the risk with other participants.
What components does a loan have? A loan usually includes financial and legal terms. The former will cover concepts such as:
Principal: The original amount lent to the borrower. In a purchase transaction, principal is the loan amount, not the asset's total price.
Term: The tenor agreed by the counterparties for repayment, in other words, the fixed time the borrower will keep the money.
Interest rate: The cost of the money related to the term. In the last article of The Compass, we already explored that any pricing for this cost should start with the benchmark rate at the time of the negotiation plus a spread; this spread will have different considerations, such as tenor, credit (the risk associated with the borrower), liquidity (the ability to sell the loan to a different lender), whether it’s an unsecured loan (no collateral) or secured (with collateral), and what type of collateral.
Repayment schedule: When and how you'll repay the loan over time, including the dates when you make interest and principal repayments (amortization).
Payment: The periodic cash amount paid to service interest and principal under the repayment schedule.
Amortization schedule: There are different ways to repay a loan's principal; usually, mortgages or car loans have equal periodic payments that ensure the debt balance hits exactly zero on the final maturity date of the agreement. Other types include partial or balloon payments, which leave a residual amount, or bullet payments, which leave the full principal outstanding until the final maturity date.
Fees: The bank can charge an origination fee, and there could also be other closing costs such as underwriting or processing fees, and insurance premiums.
These concepts might sound technical or tedious, but you’ll likely want to define them clearly if you’re lending to a relative or a friend. That way, there is no room for interpretation or later misunderstandings.
The terms agreed between lenders and borrowers are generally not known to others outside the deal because they are “private” arrangements between two or more counterparties. Public companies (those with stocks trading on exchanges) disclose their material credit arrangements in their filings.
I won’t get into legal terms, as that is a conversation of its own. Let’s say these result from the financial terms described above, covenants (what the borrower must and cannot do while the loan is outstanding), and regulatory conventions to ensure legality.
APR (Annual Percentage Rate)
Regulators require lenders to roll the interest rate and mandatory fees into one transparent percentage so borrowers can compare. This is a tool I encourage you to use when looking for financing, as it helps to compare apples to apples.
Many countries use different terminology and methodologies for this tool, but the idea remains: Canada & US (APR), EU (APRC), Mexico (CAT), Australia (Comparison Rate), Colombia (EA), Peru (TCEA), Chile (CAE), Brazil (CET), and so on.
Why does a mortgage cost less than an auto loan?
Let’s explore a mortgage:
Example 1: You buy a house for, let’s say, $100,000; the down payment is 20% plus 3% in closing fees ($2,400), both paid out of pocket, and you borrow $80,000 (principal). Your bank of choice provides a 30-year (tenor) loan. The rate is 5% (interest rate), and your monthly payments, due on the first of each month (repayment schedule), are $429.46 (payment). The APR of this loan is 5.27%
A mortgage has an amortization schedule, so the balance at the last payment is zero. This is included in the payment. In the first years, because the loan balance is high, the payment is mostly interest and little toward principal; as time passes, this ratio shifts, reducing the interest portion and gradually increasing the amortization toward principal.
What is the bank's collateral? The house itself. Because you contributed a 20% down payment upfront, the bank holds a $100,000 property backing an $80,000 loan, a collateral-to-loan coverage ratio of 1.25x (or an 80% Loan-to-Value, LTV). As explained in the last paragraph, the ratio will gradually increase. This protects the bank against your ability to keep making the monthly loan payment and against housing market swings.
Example 2. If you finance a house and a car at the same time, the mortgage will almost always carry a lower interest rate, even though the loan lasts 30 years instead of 5; this is explained because a house, generally speaking, is better collateral than a car; it should have lower intrinsic risks and, to an extent, it’s not a depreciating asset, such as a car. Housing bubbles aside, this is an asset that should, at least, hold its value, hypothetically speaking, while the car will depreciate, period. Leave the classic cars and the supply chain’s COVID crisis for another moment. It’s just how these assets behave, economically speaking. And interest rates, pricing, and appetite for longer tenors by lenders are a reflection of this.
Why are credit cards more expensive than an auto loan?
Example 3. Have you ever compared credit card APRs against mortgages and auto loans? Setting aside consumer credit considerations, credit cards are, at their core, unsecured, short-term lines of credit with no collateral. It’s just your commitment to pay the monthly installments, or the balance in full, by the due date the next month. That makes them riskier and, consequently, much more expensive.
This is why financing your life through credit cards is risky: your total debt will grow, compounding against you. I can’t emphasize this enough: don't do this. Life is sometimes tough, but financing with credit cards will undoubtedly make it tougher. Find alternatives; for example, if you own a house, a Home Equity Line of Credit (HELOC) can help.
If you use your credit card and pay the full balance by the due date each month, that’s fine. It’s a convenient way to have a very short-term loan with no interest, and you may even get miles rewards. No worries, the bank still makes money on the fees charged to retailers for facilitating their sales.
Conclusion
If you understand lenders’ perspective and the mechanics of loan-related risks, it will make your life easier and, in the event you decide to give a personal loan to a family member or a friend, at least you can try to protect your money by establishing the right terms and, hopefully, collateral in a binding document.
Now that we understand how loans work when they stay between you and a bank, what happens when that loan becomes a tradable security? That is where the bond market begins, and the focus of our next article.
For financial decisions, consult a licensed advisor in your country of residence.
Best,
