What unit economics means for a lender: what a loan earns and what it costs

One loan as the unit

Unit economics looks at a business through its smallest repeated sale. For a lender, the unit is one loan, or one borrower over the loans that borrower takes. The question is simple: over its life, does a typical loan bring in more than it costs to fund, to lose and to run?

Looking at the unit matters because totals can mislead. A loan book that grows quickly can show rising revenue while each new loan loses money, and the loss appears only later, when the loans fall due. Measuring the unit shows whether growth adds profit or adds losses.

The basic equation

A CGAP study of microcredit interest rates, by Rosenberg, Gaul, Ford and Tomilova, gives a simplified version of the formula that links a lender's income to its costs. Lenders use their income from loans to cover their costs, and the difference between income and costs is profit, or loss.

Income from loans = cost of funds + loan loss expense + operating expense + profit

The study describes each term. Income from loans is the interest, fees and other loan charges collected from borrowers. The cost of funds is the cost of the money the lender borrows to fund its loans. Loan loss expense provides for loans whose value has fallen or that may not be repaid. Operating expense is the cost of running the lending, such as salaries, depreciation and maintenance. Profit is what remains.

Measuring each part as a ratio

To compare lenders of different sizes, each part is divided by the average loan portfolio, the amount lent and not yet repaid, averaged over the year. The CGAP study and CGAP's consensus guidelines on financial ratios for microfinance define the main ratios.

• Interest yield: all interest and fee revenue from loans, divided by the average gross loan portfolio. The guidelines' yield on the gross loan portfolio counts only revenue received in cash.
• Funding expense ratio: interest and fee expenses on funding liabilities, divided by the average gross loan portfolio. The guidelines separately define the cost of funds ratio, the same expenses divided by average funding liabilities, which gives a blended interest rate on all borrowed funds.
• Loan loss expense ratio: net annual provision expense for loan impairment, divided by the average gross loan portfolio.
• Operating expense ratio: personnel and administrative expense, divided by the average gross loan portfolio. The guidelines call it the most commonly used efficiency indicator for microfinance institutions.

A dated example from the CGAP study, based on 866 lenders reporting to the MIX database: in 2011 the global median interest yield was about 27 percent. Outside India and Mexico, average loan loss fell from almost 4 percent in 2009 to a bit above 2 percent in 2011. Profit fell from about 20 percent of interest income in 2004 to about 10 percent in 2011.

Why loan size changes the answer

The CGAP study explains that it usually costs more to lend and collect a given amount of money in many small loans than in fewer big ones. Operating cost per loan rises with loan size, but less than in proportion, so operating cost per unit of money lent tends to be higher for tiny loans.

The study illustrates this with two hypothetical lenders, each with a loan portfolio of 20 million US dollars. The first has about 100,000 loans averaging 200 dollars and spends 4 million on operations: 20 percent of the portfolio, or 40 dollars per loan. The second has about 10,000 loans averaging 2,000 dollars and spends 2 million: 10 percent of the portfolio, but, divided by 10,000 loans, 200 dollars per loan. Judged by the ratio, the first looks less efficient; judged per loan, it spends less. The study calls the ratio comparison meaningless given the difference in loan sizes.

Operating expense ratio = operating cost per loan ÷ average loan outstanding

The guidelines also define a measure per client rather than per unit of money lent: cost per borrower, operating expense divided by the average number of active borrowers, or per active loan if the number of loans is used instead. For a lender, this means that the smaller the loan, the higher the interest rate needed to cover its costs. Where rates are capped, the equation implies that, for a given cost per loan, funding cost and loss rate, there is a smallest loan size that can be served at a profit. The rules comparison shows where caps apply.

A worked example: one loan, two sizes

A worked example with illustrative numbers, measured over one year for one loan. The loan's average balance outstanding is 500. The lender earns a yield of 30 percent, pays 8 percent of the balance to fund it and expects to lose 3 percent of it. Running the loan costs 75 a year.

• Income: 30 percent of 500, which is 150.
• Cost of funds: 8 percent of 500, which is 40.
• Loan loss: 3 percent of 500, which is 15.
• Operating cost: 75, which is 15 percent of the balance.
• Profit: 150 minus 40, 15 and 75, which is 20, or 4 percent of the balance.

Now the same lender makes a loan with an average balance of 200, at the same yield and the same rates of funding cost and loss. Running it costs less, 50 a year, but not in proportion to its smaller size. Income is 60, cost of funds 16, loss 6 and operating cost 50, so the loan loses 12. At 50 a year, operating cost alone is 25 percent of the balance. To break even, the yield on this loan would need to be 36 percent: 16 plus 6 plus 50 is 72, and 72 divided by 200 is 36 percent.

The same equation, applied loan by loan, shows which loans pay for themselves and which are carried by the others.

Questions to ask, and the rest of the course

The equation turns into a short set of questions for any lender, whether one's own or one being assessed.

• What does a typical loan earn as a yield, counting fees and only what is actually collected?
• What does the money lent cost, as a share of the loan book?
• What share of the book is expected to be lost?
• What does it cost to make and run one loan, and how does that compare with the average loan size?
• What is left, and is it enough to pay for the capital the lender holds?

The next lessons take each part in turn: revenue and yield, the cost of funds, credit losses, the costs of acquiring and serving a borrower, the value of repeat borrowers, and finally how the unit adds up to the business as a whole.