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Lending and borrowing transactions generally fall into two categories: direct lending and indirect lending.
These approaches differ in their structure, process, the target borrower and investor, KYC and compliance requirements, and risk assessment.
Understanding the difference between the two is crucial for investors and borrowers to make a decision on which is more beneficial to them.
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As the name implies, direct lending is when a lender provides a loan to a borrower without the presence of any intermediaries.
It is a straight forward process whereby the lender and borrower interact directly, and negotiate loan terms and rates with each other.
Usually, the lender – which are generally banks, non-banking financial institutions (NBFIs), private credit funds and associations – provides their own capital for the loan.
These are the standard traditional loans that an individual or a business takes from a bank directly, without needing to turn to a syndicated loan (a loan in which multiple banks participate).
Private credit is similar to bank loans with the exception being that the lender is not a bank but a NBFI or investment firm, such as microfinance firm or credit union.
This is when individual lenders provide funds to individual borrowers directly, usually through online platforms. For a P2P loan to be considered a form of direct lending, the p2p platform should allow both parties to negotiate terms with each other.
Direct lending comes with its own set of advantages and disadvantages. Since there is no third party intermediate, direct lending usually sees faster processing time and typically come with no additional costs such as commission and fees.
Direct lending allows for greater flexibility and can be highly customizable to an individual or business’ needs.
On the flipside, direct lending transactions can see the borrower bear the entire risk of default.
Consequently, banks require stricter due diligence and know-your-customer (KYC) requirements. This usually means that access to them is much more limited than indirect lending.
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With that in mind, direct lending is ideal when:
- A business is looking for a custom loan that is tailored to their specific needs;
Those seeking lower borrowing costs
- Speed is a priority, as borrowing directly from an institution reduces the wait time for processing;
- Individual and business borrowers that have a strong credit history.
Indirect lending is any transaction that is facilitated through a third party. The borrower and the lender do not interact directly.
While the lender underwrites and provides the loan, the borrower applies to receive it through an intermediary, who markets the service – usually at pre-set terms and conditions – and processes the application.
These intermediaries usually get a commission and charge the borrower a fee.
This is when retail outlets provide consumer financing options to customers to pay on credit.
The financing for these usually comes from banking and financial institutions but is dispersed through the retail store.
This is typified by the automobile dealerships, that provide buyers with car loans.
These are entire businesses who act as brokers that connect potential homeowners looking to borrow to buy a house with the financial institutions that actually provide the mortgage loan.
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Bonds are considered a form of indirect lending, as a financial institution (typically, an investment bank) underwrites, issues, and markets the bonds on behalf of a borrower. The actual lenders are the those that buy and hold the bonds.
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Some online platforms – including microfinance and consumer credit non-banking financial institutions – act as brokers and outlets for bank loans.
indirect lending is advantageous for borrowers who need easier access to credit, as due diligence and KYC requirements are typically less restrictive.
They also have better approval rates as intermediaries work with a number of banks to find a loan that is suitable to both parties.
The disadvantages of indirect lending typically include higher costs, as third parties typically charge commission and fees,
as well as providing borrowers with less flexible terms and conditions since they do not negotiate directly with the lender. These transactions also have longer processing times as intermediaries are responsible for due diligence.
Indirect lending is ideal when:
- Borrowers with a limited credit history
- The borrower is looking for convenience in accessing the loan
- Businesses and individuals do not meet strict requirements for approval
- Borrowers are looking for a variety of options to borrow
- Large organizations looking for large enough capital to warrant a bond issuance.
Disclamer:
This post is for educational purposes only, and the Firm does not directly or indirectly provide these services.
