What is private credit?
Private credit is generally defined as any lending or debt arrangement in which one of the parties involved is a private entity. Generally, it refers to private loans which aren’t issued by banks, meaning the word “private” refers to the lender, not necessarily the borrower. The underlying concept is the same as it is with all forms of debt. One party, the lender, gives a sum of money to a borrower in the present. The borrower agrees to repay the lender over time, plus interest. The lender gives up cash in the short term in order to receive a return from repayments in the long run.
Private credit is a way for both investors and borrowers to bypass big banks to create mutually beneficial loan arrangements. Private credit helps borrowers get access to capital, while allowing lenders to earn higher returns than they would with traditional debt offerings. These higher returns, naturally, are the byproduct of a higher degree of risk, as borrowers turning to private options may have poor credit or lack collateral.
How does private credit work?
First, while nearly everyone has some experience with debt as a borrower or lender, let’s just look at the basics. Debt is often called ‘fixed’ income because the payments are usually made at a fixed rate and a fixed schedule. The date when the loan is fully paid off also has a name - it’s called the maturity date. The term of the loan means how long the loan lasts. Another key term is the principal, which means the sum of money initially borrowed. The interest means how much a borrower pays on top of the principal they originally borrowed, and the interest rate expresses this as a percentage of the loan.
For example, if a borrower takes out a 1-year, interest-only loan for $10,000 with an interest rate of 6%, the details are as follows:
Principal: $10,000
Interest Rate: 6% annual percentage yield (APY)
Term: 1 Year
Payment Schedule: Monthly
Amount Owed Per Month: $50
Total Return: $600 (6% interest)
For an investor, private credit is a fairly straightforward process when going through a specialized online platform. Of course, anyone can lend money to anyone, but it is advisable to do so through official channels - platforms that are SEC-regulated and handle all the legal paperwork. In exchange, they collect a fee from both borrowers and investors for the provided services.
The process starts when a potential borrower interested in obtaining a loan completes an online application on the platform, which then assesses the application and determines the risk and credit rating of the applicant. If the application is approved, the applicant receives the available options for loan amount, interest rate and loan term. After the applicant receives their loan, they are responsible for paying periodic (usually monthly) interest payments and repaying the principal amount at maturity. As an investor, if you choose to invest in that particular loan, you will receive your share of the payments every month and your share of the principal when the loan matures. Platforms generally allow investors to select individual loans to invest in or to take a hands-off approach by investing in set portfolios containing a certain class of loan or a certain type of loan.
Depending on the platform being used, there may be a buyback guarantee, in which case the platform commits to repaying the debt should the borrower default. Others have default provision funds in which an emergency pool of money can be used in instances of distress. It’s up to you to understand what protections each platform offers, if any, before loaning your capital.
