Part 01 — Foundations & Market

How Lenders Make Money

SME lending revenue starts with interest, but a lender’s profit pool is wider and more constrained than the headline borrower rate suggests. A non-banking financial company (NBFC) may earn interest spread on its own book, processing and servicing fees, insurance distribution commission, subvention income from anchors, direct assignment gains, securitisation residual income and co-lending fees. Each line has a conduct rule attached. The useful question is not “what can be charged?” It is “what survives the Key Facts Statement (KFS), annual percentage rate (APR), penal-charge, prepayment and mis-selling tests?”

Interest and NIM

On a pure own-book loan, the core formula is:

net interest margin (NIM) = portfolio yield - funding cost allocated to the loan book

Published lender disclosures show how wide the range is. Five-Star Business Finance said its FY2024-25 incremental seven-year loan rates were reduced to 21.5-22.5 percent from 24.5 percent, while its gross stage 3 assets were 1.79 percent and AUM was ₹11,877 crore (Five-Star FY2024-25 directors’ report). UGRO Capital’s September 2025 investor presentation showed a 17.6 percent portfolio yield and 10.37 percent cost of borrowings (UGRO Q2 FY2026 presentation mirror). Kinara Capital’s published pricing policy is unusually explicit: it uses 14.5 percent weighted average borrowing cost, 7.5 percent operating cost and 4.0 percent base RoA to form a 26.0 percent benchmark rate, with loan rates from 14-36 percent reducing balance (Kinara interest-rate policy).

The lender’s interest spread is therefore not pure profit. It pays for origination, underwriting, servicing, collections, credit loss, liquidity buffers, technology, taxes and capital.

Fee Stack

Common SME-lending fee lines are:

Fee or income line	Revenue logic	Honesty constraint
Processing fee	Usually a percentage of sanctioned or disbursed amount.	Must be disclosed in KFS and included in APR where applicable under RBI’s KFS circular for retail and MSME loans (RBI KFS circular, 15 April 2024).
Documentation, legal and valuation charges	Recovery of transaction costs, especially secured loans.	Third-party amounts recovered by the regulated entity must be separately disclosed and included in APR if recovered by the lender.
Bounce charges	Cost and deterrent for failed NACH, cheque or mandate presentation.	Must be reasonable, disclosed and not disguised as penal interest.
Penal charges	Charge for breach of material terms, including default.	RBI says penalty must be penal charge, not penal interest, and cannot be capitalised (RBI penal charges FAQ, 15 January 2024).
Foreclosure or prepayment charge	Revenue protection when a borrower closes early.	RBI’s 2025 prepayment directions restrict charges on covered floating-rate loans to individuals and micro and small enterprises from 1 January 2026; applicability depends on lender type, borrower and loan amount (JSA summary of RBI Pre-payment Charges on Loans Directions, 2025).
Insurance distribution	Commission or fee from optional insurance attached to the loan.	Must not be forced or mis-sold; borrower consent and cost disclosure matter. Where source documents are not public, treat commission economics as unverifiable.
Subvention	Manufacturer, platform or anchor pays part of interest or fee to reduce borrower-visible cost.	Must be reflected in true APR and accounting treatment.

The practical rule is simple: if the borrower must pay it to receive or keep the loan, the KFS and APR treatment should catch it.

Co-lending Economics

In co-lending, two regulated entities share a loan. The 2025 co-lending directions require each participating RE to retain at least 10 percent of each individual loan; 80:20 is still common market language but not a mandatory split (RBI Co-Lending Arrangements Directions, 6 August 2025). The borrower receives one blended rate:

borrower blended rate = (bank share x bank loan rate) + (NBFC share x NBFC loan rate)

Worked 80:20 example, labeled as an assumption:

Assumption	Value
Bank share	80%
NBFC share	20%
Bank rate on its share	16.5%
NBFC rate on its share	24.0%

Formula:

blended borrower rate = (80% x 16.5%) + (20% x 24.0%) = 18.0%

The bank may like this because it gets MSME exposure through a sourcing and servicing partner. The NBFC may like it because it can originate ₹100 crore while retaining only ₹20 crore of balance-sheet exposure. The constraint is operational: escrow, split ledgers, bureau reporting, customer service, NPA mirroring and fee disclosure must work daily.

DLG-Backed Sourcing

Default loss guarantee (DLG), formerly called first-loss default guarantee (FLDG), is not interest income. It is a loss-support arrangement where an eligible provider bears a pre-agreed share of default loss. RBI’s digital lending framework capped DLG at 5 percent of the outstanding loan portfolio and restricted eligible guarantee forms, with DLG now consolidated in the Digital Lending Directions, 2025 (RBI Annual Report 2023-24 DLG summary, RBI Digital Lending Directions, 2025 mirror).

For a platform, DLG-backed sourcing revenue may be a service fee paid by the regulated entity. The economics are fragile:

platform profit = platform/service fee - acquisition and servicing cost - DLG calls - cost of DLG collateral

If DLG calls rise from 2 percent to 5 percent of outstanding, a profitable sourcing channel can become a capital drain even though the platform has no loan book.

Off-Book Income

Off-book AUM is not free income. It usually comes through:

direct assignment, where a pool is sold to another lender or investor under transfer-of-loan-exposure rules;
securitisation, where receivables are pooled and securities are issued with credit enhancement;
co-lending or co-origination, where the partner books most of the exposure;
business correspondent or managed-book servicing, where the platform or NBFC earns service income.

UGRO reported off-book AUM at 43 percent in September 2025 (UGRO Q2 FY2026 presentation mirror). MAS Financial’s FY2026 earnings call guidance referred to maintaining off-book assets at 20-25 percent of AUM (MAS Q4 FY2026 call summary). These are business-model choices. Off-book improves capital velocity, but creates reconciliation, eligibility, representation-and-warranty and investor-confidence risk.

Centerpiece: ₹100 Crore Monthly Disbursals

The following is arithmetic, not a forecast. It models the same ₹100 crore monthly disbursal engine under three structures. Assumptions are deliberately labeled.

Common assumptions:

Assumption	Value
Monthly disbursal	₹100 crore
Annual disbursal	₹1,200 crore
Average tenor	24 months
Repayment pattern	Equal principal amortisation
Mature average AUM formula	`monthly disbursal x (tenor + 1) / 2`
Mature average AUM	`₹100 crore x 25 / 2 = ₹1,250 crore`
Tax on positive pre-tax profit	25%

A. 100 Percent Own Book

Assumptions: borrower yield 24 percent, processing fee 2 percent of annual disbursal, NBFC cost of funds 11 percent, debt funds 85 percent of AUM, opex 6 percent of AUM, credit cost 4.5 percent of AUM, equity 20 percent of AUM.

Line item	Formula	₹ crore
Average AUM	`100 x 25 / 2`	1,250.0
Interest income	`1,250 x 24%`	300.0
Processing fee income	`1,200 x 2%`	24.0
Finance cost	`1,250 x 85% x 11%`	(116.9)
Operating expense	`1,250 x 6%`	(75.0)
Credit cost	`1,250 x 4.5%`	(56.3)
Pre-tax profit	Sum above	75.8
Tax	`75.8 x 25%`	(18.9)
Profit after tax	`75.8 - 18.9`	56.8
RoA	`56.8 / 1,250`	4.5%
RoE	`56.8 / (1,250 x 20%)`	22.7%

B. 80:20 Co-lending, NBFC View

Assumptions: same borrower engine, bank books 80 percent, NBFC books 20 percent, blended borrower rate 18 percent, NBFC rate on retained share 24 percent, bank rate on bank share 16.5 percent, NBFC servicing fee 1 percent of bank AUM, processing fee 1.5 percent of annual disbursal, NBFC opex 3.5 percent of managed AUM, NBFC credit cost 2.5 percent of retained AUM, NBFC debt funds 80 percent of retained AUM at 10.5 percent, NBFC equity 20 percent of retained AUM.

Line item	Formula	₹ crore
Managed AUM	Common mature AUM	1,250.0
NBFC retained AUM	`1,250 x 20%`	250.0
Interest income on retained share	`250 x 24%`	60.0
Servicing fee	`1,000 x 1%`	10.0
Processing fee income	`1,200 x 1.5%`	18.0
Finance cost	`250 x 80% x 10.5%`	(21.0)
Operating expense	`1,250 x 3.5%`	(43.8)
Credit cost	`250 x 2.5%`	(6.3)
Pre-tax profit	Sum above	16.9
Profit after tax	`16.9 x 75%`	12.7
RoA on retained AUM	`12.7 / 250`	5.1%
RoE on retained equity	`12.7 / (250 x 20%)`	25.4%

The co-lending model can improve NBFC capital velocity, but the operating expense is still on the full managed book. If servicing cost or bank-partner reconciliation cost is understated, RoE collapses quickly.

C. DLG-Backed Sourcing for Another Balance Sheet

Assumptions: platform is not the lender; it earns a 5 percent platform fee on annual disbursal paid by the lender, posts DLG collateral equal to 5 percent of outstanding portfolio, incurs 2 percent acquisition and servicing cost on managed AUM, and absorbs DLG calls equal to 2.4 percent of managed AUM. The 5 percent platform fee and 2.4 percent DLG call are assumptions, not disclosed market facts.

Line item	Formula	₹ crore
Managed AUM	Common mature AUM	1,250.0
Platform fee income	`1,200 x 5%`	60.0
Acquisition and servicing cost	`1,250 x 2%`	(25.0)
DLG calls	`1,250 x 2.4%`	(30.0)
Pre-tax profit	Sum above	5.0
Tax	`5.0 x 25%`	(1.3)
Profit after tax	`5.0 - 1.3`	3.8
DLG collateral required	`1,250 x 5%`	62.5
Return on DLG collateral	`3.8 / 62.5`	6.0%

This is why DLG-backed origination is not a magic fee business. A small deterioration in vintage loss can consume the entire fee pool.