Recently, I’ve started to invest more in LendingClub notes. The interest rates you can earn at LendingClub are significantly higher than even a high yield savings account or CD, and p2p lending is a good way to diversify an investment portfolio. But there is a significant downside with this strategy–risk.
Investing in consumer loans involves a significant risk of default. And in fact two of the loans I’ve invested in were not fully paid. While LendingClub does a good job of avoiding the highest risk loans (a minimum credit score of 660 is required of all borrowers), any investor needs to realize that there is a chance the borrower won’t pay the loan in full.
Risk of Default and LendingClub’s Interest Rates
Now this is where things start to get interesting. LendingClub calculates a borrower’s risk of default and reflects that risk in the interest rate for that loan. The risk of default is based on a number of factors, starting with the borrower’s credit score from TransUnion. Based on the borrower’s credit score, they are placed in what LendingClub calls a Loan Grade of A through G. LendingClub then assigns the borrower a sub-grade based on a number of factors:
- Requested loan amount
- Number of recent credit inquiries
- Credit history length
- Total and currently open credit accounts
- Revolving credit utilization
- Loan maturity: 36 or 60 months
You can get an idea of the grades, sub-grades, and interest rates in the charts below:
LendingClub’s 60-Month Loans
Now this presents a dilemma for investors. Do you seek the highest rates possible, along with the highest risk of default, or do you play it safe with Grade A loans? With LendingClub’s introduction of 60-month notes, there is an alternative that can increase your returns without a significant increase of default risk.
When LendingClub first launched a few years ago, the only option was a 36-month loan. Today it also offers a 60-month note. These longer notes bear higher interest rates than 36-month loans even for the same credit score and other default risk factors. In other words, you can get higher rates without a significantly high risk of default.
But as the saying goes, there is no free lunch. So what does this approach cost you? First, you have to tie up your funds for 60 months rather than 36 (also known as liquidity risk). Second, and related, you increase what is called < a href=”http://en.wikipedia.org/wiki/Interest_rate_risk”>interest rate risk. The risk here is that during the 60-month term, interest rates may go up. If that happened, you’d have money invested in a loan at a lower rate than you could get at the then prevailing rates. Of course, a 36-month note also exposes you to interest rate risk. But the longer the term, the high the risk. The great thing about LendingClub, however, is that you can diversify by investing in both 36-month and 60-month loans.
Putting 60-Month Notes to Use
So now the question is how do we go about implementing this strategy in LendingClub. Fortunately, it’s extremely easy. LendingClub.com’s investing page offers several portfolios you can choose, each with varying risk. These options can be filtered based on the term of the loan (36 months, 60 months, or both), the borrower’s credit score, and Loan Grade (A through G). For our purposes, we’ve filtered the investing options to include only those borrowers with a credit score of 780 or higher. The idea here is to minimize the risk of default. Of course, when we do that, the expected rate of return goes down, too.
The image below shows the three options LendingClub presented to me based on 36 month loans only and a credit score of at least 780:
As you can see, Option 3 offers the highest projected return (and highest risk) of 9.51%. Now, if instead of limiting the options to 36 month loans, we also include 60 month loans, the returns and risk change significantly:
Now it’s important to understand the details behind these changes. For each option, LendingClub provides a wealth of information about the portfolio, including the Grades of the notes included in the portfolio, the term of the notes, and the projected default rate and interest rate. So let’s compare Option 3 for portfolios that exclude and include 60-month notes (both limit borrowers to those with credit scores of 780 or above).
First, the portfolio that excludes 60-month notes:
Now the portfolio that includes 60-month notes:
As you can see, the expected default rate goes from 1.07% with just 36-month notes to 2.01% when we include 60-month notes. But the projected return goes up by nearly 3%.
So have we found some glitch in LendingClub’s model that allows us to significantly increase projected returns with just a modest increase in expected default rates? Absolutely not. As I said before, there is no free lunch.
By including 60-month notes, we are exchanging default risk for interest rate and liquidity risk. All of that is a fancy way of saying our money is tied up for 60 months instead of 36 months. But if nonpayment is the risk you are most concerned with, this strategy may be worth considering. It’s the strategy I’m taking, and I’ll let you know how it’s working as my portfolio grows.
If you’ve never invested in LendingClub notes before, you can visit LendingClub’s investment page to see if p2p lending is right for you.