The difference between maturity and duration

A key component of any loan is its maturity: the time the borrower has to repay the loan amount. Lenders also care about maturity, but not for the same reason as the borrower. Loans are often packaged and sold on the secondary market - a market in which most healthcare entrepreneurs don't play. A loan's maturity impacts the value of the loan in the secondary market - that valuation can help or hurt a lender in the short term as it arbitrages the loan. Let's take a look at loan value, maturity, and duration to better understand how loans work.

Value of a loan

Perhaps surprisingly, the value of a loan is not the loan amount. A loan's value comes from the willingness of investors to buy or sell it in the secondary market. And a key influencer of that value is not the underlying contractual terms of the loan - terms under which the borrower and original lender created the loan. Rather, loan value is heavily influenced by prevailing interest rates. How susceptible a loan is to interest rates will affect its value - a susceptibility that can be quantified and followed over time using the loan's duration.

Loan arbitrage

Loan arbitrage is a near-universal action in which lenders and investors partake. In order to understand arbitrage, one must first understand the three (3) (yes, you read correctly...three) stakeholders in the loan business: borrower, lender, and investor. The first two are pretty obvious: the borrower (entrepreneur) and lender (bank) enter into a contractual agreement for a specific amount of debt (principal), to be paid within a specific amount of time (maturity), and at a specific cost (interest). Once the loan is created, the borrower goes about his/her business making steady monthly payments (learn about the types of loan payments here). 

The lender, however, is in a predicament. Even though it (the bank) will earn interest from the loan, that interest will come piecemeal over the lifetime of the loan. And the initial loan amount (principal) won't be paid in-full until the loan matures (which could be years from today). How does the lender make substantial return on a loan with a 10-, 20-, or 30-year maturity if it doesn't want to wait that long?

Arbitrage is the rapid buying-and-selling (or rapid selling-and-buying) of an asset - in this case, the loan is the asset. Lenders create a loan with a borrower and then sell it to investors in the secondary market. The sale price of the loan, however, depends on a number of immutable and mutable factors:

Since the immutable factors are, by definition, unchangeable, investors and lenders care how the prevailing interest rate affects the value of the loan. 

Maturity versus duration

Although loan maturity and loan duration sound similar, they are very different. Loan maturity is the contractual amount of time a borrower has to repay the principal. Loan duration, however, helps investors price a loan for purchase in the secondary market. Duration depends heavily on the underlying loan parameters: immutable parameters such as the interest rate and maturity itself. In its simplest interpretation, a loan's duration tells the investor how long (time) it takes to recover the amount of the loan made at t = 0.

The shorter the duration, the less susceptible the loan value is to prevailing interest rates. The longer the duration, the more susceptible. Not only does the loan duration give you information about the magnitude of the effect that a change in interest rates has on the loan value, but it also provides directionality (increase or decrease). Thus, the loan duration provides 3 key pieces of information for an investor who wants to buy the loan:

1. the time it takes for the lender to recover the initial loan amount (in the above case, the time it takes to recover $25K),

2. the change in loan value for every 1% change in prevailing interest rates, and

3. the direction of change in the loan value when the prevailing interest rate changes.

Loan durations are important to both lenders and investors who transact in loans. Most borrowers are blind to a loan's duration or the effect prevailing interest rates have on their loan's value. Loan arbitrage is more common than most borrowers know and one of the key metrics to a successful arbitrage is the loan duration.

For details on loan durations, click here.