What is the rate of return?

The lending industry has run a revolution across the globe through the early 2000s. An economy is run by funds that are limited but the needs are unlimited. The basic objective behind any lending or investing is the rate of interest or ROI. The rate of return on loans can vary across a range of different factors. The banks and the financial institutions are the common access point of resources available and accessible to all. The need of the amount of loan and the purpose of the loan may vary but the banks calculate the rate of interest on a loan according to their carefully designed policies and conditions. 

The risk and return on a loan are the two critical indicators. The returns are inversely proportional to their risks. Risk appetites of the bank and the borrower are different. The interest rate is calculated considering all the considerable points from both points of view. The calculation of the rate of return from a loan is defined by the total earnings net of the cost of lending divided by the total amount lent. Investors are concerned with the extent of borrowings taken by a company to estimate the depth of the roots of a company. 

Calculating ROI on a loan

The calculation of the ROI of a loan using the ROI formula is a simple quotient exercise. However, while calculating its parameters, evaluating the ratio, and drawing worthy conclusions is a brain exercise. The ROI becomes an asset for the lender in terms of its profit contributions and the strength of the recovery mechanism. A business loan is the major source of income for any bank or financial institution. ROI is calculated using the following formula:

$\mathrm{ROI} (\%) = \frac{\mathrm{Net} \mathrm{Income}}{\mathrm{Principal} \mathrm{Amount}}\times 100$

Peer-to-Peer lending

Peer-to-peer lending refers to a contractual agreement between the borrowers and the investors where the lending platform acts as a facilitator and mediator between them. The underlying importance of this financing alternative is attributed to the prompt, paperless, hassle-free, unsecured, and relatively harmless terms and conditions. This market has seen a benchmark IRR of 25% over the past decade. The sweeping recession attributed to the aftermath of coronavirus disease 2019 has further escalated its essentiality across the globe.

The lending club

The world leader in peer-to-peer lending is the lending club. Since its inception around two decades ago, the platform offers an extraordinarily satisfactory return to the investors and all kinds of loans ranging from business to unsecured loans to the borrowers. The growth and ROI of this company have been a topic of financial awareness among the banks and investors. The interest rate of these peer-to-peer loans compete with the other financial aids and bring about an awareness that can become an asset from liability and how the historical data has been used by experts to serve the society by easing the future payments of the loans especially the business loans. This ensures quick amortization of the outstanding principal of the loan and accelerates the annual growth rate both for the borrowers and increases their internal rate of return/expected return meanwhile ensuring the holding period for the investors does not prolong to make them incur opportunity costs. The risk of default is managed to remain low by ensuring the correct compliance before investing. The expected return of an investor is kept in mind before giving the loan.

Methods of calculating the rate of return/ROI

The calculation of the rate of returns/ROI is important in arriving at the annualized return estimates. To calculate the ROI, several methods and dynamic aspects are followed, some of the common methods are:

The simple method of ROI

Annualized return on the loan can be calculated by dividing the difference of the ending balance and the opening balance for the period by the cost of the investment multiplied by 100. The adjusted annualized returns are the annualized returns adjusted for the defaults, losses, and servicing charges.

 Extended Internal Rate of Return (XIRR) using Newman's method

To find the rate of return/ROI by strategically analyzing the deposits and withdrawals into an account, Newman's method of iteration to arrive at the XIRR (Extended Internal Rate of Return) is followed. Investors usually consider this for calculating their expected return. This formula involves recording all cash flows during the loan period in a column and all the dates corresponding to those in another column. Then, use the XIRR formula in a specified cell different from the data range and select the date and amount values. Thus, arriving at the XIRR as shown below:

Fair value method

The fair value method is the prominent method to arrive at the feasibility of a loan. It takes into account the cash flow values of the loan and discounts to arrive at the net present value (NPV). This value is then put into the ROI formula to calculate the exact rate of return over the holding period and divided by the number of years/quarters for calculating the fair rate of return on the loan to the investors. This method incessantly considers the element of risk involved in any money investment and the risk of default involved in any lending exercise.

Context and Applications

The rate of return on a loan is a field of massive expertise and the world's biggest entrepreneurs and regulators consider this parameter as the base of any lending or borrowing decision. This concept is studied in:

• Bachelors in Finance
• Masters in Finance
• Masters of Business Administration
• Bachelors of Business Administration
• Chartered Financial Analyst

Practice Problems

Question 1: What is the syntax of the XIRR (Extended Internal Rate of Return) formula?

1. 1. =XIRR(values,dates,(guess))
   2. =XIRR(values,dates,[guess])
   3. =XIRR(dates,values,[guess])
   4. =XIRR(dates,values,(guess))

Answer: (b)

Explanation: The syntax of the XIRR is =XIRR(values,dates,[guess]).

Question 2: What is the annualized rate of return if the quarterly rate of return is 5%? 

1. 1. 20%
   2. 15.25%
   3. 21.55%
   4. 15.76%

Answer: (c)

Explanation: If the quarterly rate of return is 5%, then the annualized rate of return can be determined using the following input values in the formula $[{(1.05)}^4 - 1] \times 100$] which yields the result as 21.55%”.

Question 3: What is the significance for an investor if the net present value (NPV) is zero? 

1. 1. Do not Invest
   2. Invest
   3. No profit, no loss situation
   4. Risk is high

Answer: (c)

Explanation: If the net present value (NPV) is zero, it doesn't necessarily mean that the investment is meaningless. Hence, the correct conclusion is that the investment will neither yield profits nor it will cause any losses.

Question 4: What is the term used for defining the agreement of lending between two or more parties on a digital platform? 

1. 1. Peer-to-peer lending
   2. Informal Mortgage 
   3. Commercial paper
   4. Securitization

Answer: (a)

Explanation: Peer-to-peer lending refers to a contractual agreement between the borrowers and the investors where the lending platform acts as a facilitator and mediator between them. 

Question 5: What is the significance of dates in the XIRR method?

1. The outstanding principal of the loan is insignificant.
2. The date of payment is used for calculating the number of days between two consecutive transactions.
3. XIRR considers dates for grouping the transactions in years.
4. None of the above

Answer: (b)

Explanation: The date of payment is used for calculating the number of days between two consecutive transactions so that the time interval is taken into account.

Common mistake

The students must keep in mind the point of view of both the lender and the borrower in studying this concept. The expected return for an investor is the direct determiner of the period to amortize the investment. The debt for the borrower will get heavier with the rise in the term of the debt payment also.