Filtering Loans – Part 1: Risk and Statistics

Part 1 – Introduction: Risk
Part 2 – Avoiding Defaults
Part 3 – Low-Grade Loans
Part 4 – Multiple Filters
Part 5 – From Tools to Platforms

Lending Club and Prosper both give you the ability to filter their available loan pool. The quality of your filter will strongly affect whether your notes become healthy or unhealthy over time. Lenders with good filters are less likely to experience defaults and more likely to have thriving consistent returns. A good filter is key.

So what is the recipe for a good filter? To answer that question, let’s take a minute to look at a basic element of investing in general, particularly the idea of risk.

Good Risk and Bad Risk

Anytime you loan money, you are going to be examining and weighing risk. If a friend asks to borrow $500, we first consider the person who is asking.
What if your friend:

  • Is always behind on his rent
  • Can’t hold down a job
  • Never chips in money for beer

Most of us would not loan him $500 (or at least would just call it a gift), knowing that the chance (risk) that he would not repay this loan would be quite high.

If we minimize our risks in life, we decrease the chances that something bad will happen. This is why people buckle their seatbelts, study for their classes, and remember to let the dog out before bed. Doing these things makes life more stable and enjoyable.

hikerThis is not to say that risk is always a bad thing. Sometimes, risky things are how anything amazing happens at all! I have a friend, a chef, who started a restaurant with a $200,000 investment from her parents. Her parents took a big risk loaning her this money. There was a good chance her restaurant would fail, as many restaurants do. However, by this point in her career my friend had already succeeded at a few businesses, proving to her parents that she was a skilled chef. Plus, she was their daughter and they trusted her. When she told them she had an awesome business idea, they believed her. My friend now owns one of the more famous gourmet restaurants in the Pacific Northwest.

In life, nothing is certain, but some things are surer than others. As we live our lives, we learn where the world is consistent. We slowly become aware of which foods our spouse will enjoy or which friends we can count on for help. This habit of filtering is a basic element of life, of investing, and a major part of peer to peer lending.

Risk by the Numbers

While it is easy to casually reduce normal everyday risk, imagine if you had to engage thousands of instances of risk at once. Things would become very difficult. And what if we tried to grapple something really complicated, like evaluating the financial stability of 100,000 different people? We would have to examine all their different bank statements and spending habits. We would have to come with all of them to their thousands of places of work and see if they were good employees. The process would take so long that nothing would ever get accomplished. Thankfully, there is a way to avoid all this work: using numbers.

Looking at the world through numbers makes evaluating people much simpler. First, we can approach a hazy thing like financial responsibility, and make it numeric. We can move from a huge question like “How financially responsible is Simon?” to a simple number like a credit score (730) that provides a summary for that question. With numbers, evaluating someone’s risk becomes a much quicker process.

two borrowersOnce we can describe people numerically, we can then place them in large groups and run statistics to organize those numbers. Now, not only do we have a measurement like a credit score for an individual borrower, but we can also do some basic statistics to see that people with similar credit scores act in similar ways.

Open Digital Platforms

Using some simple statistics is a key to success within peer to peer lending. This is only possible because the platforms are wonderfully transparent. Both Lending Club and Prosper have given us access to all the borrowers and loans in the history of peer to peer lending – the good and the bad. Very little is hidden from us. This history contains tons of information, including the credit reports of all their borrowers.

Good and Bad Risk in Peer to Peer Lending

Conveniently, websites like have tools we can use to analyze borrower history and get a picture of which loans might perform best. These online tools are excellent at understanding the presence of risk within peer to peer lending. They help with identifying bad risk that we want to avoid, such as avoiding borrowers who might default. They also are great for identifying good risk, such as high-quality low grade loans that often have interest rates over 15%.

Using some simple statistics, we can set up filters to grapple risk and have great peer to peer lending returns. These two kinds of risk, good and bad, are the two elements of using filters.

In part 2 we look at how to avoid bad risk and lower our defaults.

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[image credit: flikr ‘flikr1077‘/Jodie Wilson ‘zipline‘ CC-BY 2.0]

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