In the distant past, the Halflings had lived alongside Men in the northern Vales of Anduin. They shared the Mannish language of the Big Folk among whom they lived, and in that language they came to be known as Holbytlan, 'hole-builders', referring to their habit of dwelling in holes dug into hills and banks. Eventually both Hobbits and Men left that region and travelled to widely separated areas of Middle-earth.
The Halflings themselves came to use a corrupted version of Holbytlan, 'Hobbits', which was originally a name for the Harfoots used by the Stoors and Fallohides. When they travelled west of the Misty Mountains, they adopted the Common Tongue spoken in that part of the World, but the name 'Hobbit' survived as this people's own preferred name for themselves.
Meanwhile the descendants of Men eventually settled in Rohan. There the original name Holbytlan was preserved, but the people to whom it referred had passed out of memory and become creatures of legend, who were said to be able to vanish in an instant, trill like birds, and to dwell in holes burrowed into sand-dunes1. It was not until the Rohirrim encountered Merry and Pippin at Isengard that they realized their ancient word Holbytlan described a living people.
Holbytlan is the plural form, equivalent to 'Hobbits', while the singular is Holbytla (as in 'Master Holbytla', commonly addressed to Meriadoc Brandybuck during his time in Rohan). In fact the word Holbytla is Old English, used by Tolkien to represent the Mannish language of the ancestors of the Rohirrim, and the word actually used in Rohan was kûd-dûkan, said to mean 'hole dweller'. The worn down form of this used by the Hobbits themselves, and thus the actual word translated by Tolkien as 'Hobbit', was kuduk.
The legend in Rohan that the Holbytlan dwelt in sand-dunes seems oddly specific, especially given that historically the ancestors of the Rohirrim and the Hobbits lived together in the Vales of Anduin, where presumably sand-dunes were rarely to be seen. It's hard to be sure how significant this might be, but it could hint at an even earlier stage of the history of the Hobbits, in which they actually lived among dunes of sand. It's notable that even in the Shire the Hobbits preserved legends of a Last Desert in the far east of Middle-earth. Based on the folk tales of Rohan, this might even have been where Hobbits originated, though the direct evidence for this is admittedly rather flimsy.
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