When investing in peer to peer loans, loan default is the most significant risk factor that can erode your return on investment. When a loan is issued to a borrower they agree to repay the money to investors at a fixed rate. Investors expect to see that rate minus service fees equal their return on investment. But, in reality that is wishful thinking. Not every borrower is going to live up to their debt obligations, and when they don’t, you may not only see your profits dwindle, but could even lose a large chunk of your investment.
What is loan default?
Loan default is a term used to describe a loan in which a borrower is not living up to their obligations as specified in the contract for the loan. In peer to peer lending we focus specifically on debt service default, which simply means the borrower missed one or more payments.
When a loan becomes late, Lending Club and Prosper will take care of attempting to recover the payments by contacting the borrower. Individual investors are not allowed to perform this activity on these sites.
When it is determined that a loan is very unlikely of receiving any further payments, it is charged off. This charge off is a declared for tax purposes, essentially letting you declare the loan investment a loss on bad debt.
The Effect of Loan Defaults on Your Return on Investment
As a lender, when a loan defaults, you may not only see the expected profits from your investment disappear, but you run the risk of losing the unpaid amount of your investment. So potentially, if you invest $25 in a loan note for which the borrower never makes a payment, you not only lose the expected interest payments, but the entire $25 investment.
As another example, let’s say you have 100 loans, all with a 15% fixed rate and your portfolio has a default rate of 5%. Your portfolio would see a return of investment of only 10%, minus any servicing fees.
Since the loan is set at a fixed rate, and the borrower will never volunteer to pay you a higher rate, the rate of the loan minus service fees is the maximum potential you will see from your investment. And the only way you will get less is if the borrower doesn’t pay you in full. So an effective peer to peer loan investment strategy sets out to invest in loans with the largest fixed rate and the lowest loan default rate.
Loan Defaults at Lending Club vs. Prosper
The following chart is from Nickel Steamroller and shows the historic default rates for Lending Club and Prosper.
Nickel Steamroller - P2P Lending Default Rates
Both Lending Club and Prosper publicize returns by credit grade, which are discounted by the historical default rates. You can view those figures here and here, respectively. Prosper explicitly lists a Loss Rate, where for Lending Club you can click the Performance link under the page header to see Average Interest Rate by Credit Grade. Subtracting the expected return from the average rate will give you an estimated loss amount on LC. You can also use a more powerful tool like LendStats to provide you average rate of loss for each site.
Minimizing Risk of Loan Default
Your first objective should be to diversify your portfolio, to spread the risk of default across many notes. As an example, let’s see what happens when a single note becomes charged off on a $1,000 portfolio. In one case we’ll pretend the note investment was $25 and in another we’ll say we invested $250.
- 25 / 1000 = 2.5% loss
- 250 / 1000 = 25% loss
Secondly, you should take a strategic approach for picking low risk loans by analyzing risk factors to look for in a listing. According to Prosper, the following factors from a borrower’s credit report play the most significant role in determining the risk of loan default:
- Debt-to-income ratio
- Loan amount
- Now delinquent
- Inquiries in last 6m
- Bankcard utilization
Lastly, if all else fails, minimize your losses and sell a note when it is in the early stages of being late at a discount on FOLIOfn. Lending Club investors are able to put late loans for sale on the secondary market for other investors to purchase.
Based on my analysis of Lending Club’s historical data, any number above two inquiries in the last 6 months has a very high rate of default (ranging from 11% up to 42%), but fewer then 12% of borrowers actually have that. Also, debt-to-income ratio has a fairly low default rate (5% – 8%) across the various ratio’s.
I think a more important and more common indicator of default risk is anything dealing with delinquencies. A bit over 35% of borrowers have had some sort of delinquency in the past decade, with default rates range as high as 14% for those who recently had a delinquency. It is a bit surprising to see Lending Club allow this many borrowers through with bad credit history.
Any way you go about choosing the loans you invest in, there’s always a chance the borrower will end up defaulting no matter how careful you are screening for bad attributes. So your point about spreading out your investments in $25 chunks is probably the most important.
@Jerry – thanks for the reply. I agree with your points and in future posts will break some of these risk factors down a bit further. BTW, I hope you continue to build up your site, it is off to a good start.
“As another example, let’s say you have 100 loans, all with a 15% fixed rate and your portfolio has a default rate of 5%. Your portfolio would see a return of investment of only 10%, minus any servicing fees.”
Your portfolio would see an ‘expected’ return of 10% minus any servicing fees. That 10% isn’t guaranteed especially on a 100 note portfolio. It could be higher or lower (probably lower). You’ll have better luck hitting the expected return with a 400 note portfolio.
Lou
@Lou
Thanks for your comment. In my hypothetical example, I have set a constant rate of loss on my portfolio at 5%. So, the intention here would be the equivalent of looking back on a portfolio where now all loans are either fully repaid or charged off. So, no, you couldn’t arbitrarily be hit by further loss the way I intended this scenario to read. I’ll probably tweak the wording to be more clear. To your other point, I agree a 100 note portfolio would be poorly diversified.