While avoiding bad risk (defaulting loans) might be the main reason we use filters, we also want to consider taking on some good risk – namely in the form of adding some lower grade loans. This is because adding some risk can be really rewarding! Let’s look at an example and do a filtering exercise to discover the potential in riskier low grade loans.
Vacation: The Beach or the Jungle?
To understand loan grades, let’s imagine you begin to feel burned out and decide to go on a vacation. Say you are at lunch with two friends and you break this news to them. They get excited, because each of them had been planning a vacation themselves. Each friend asks you to join them, but each of their vacations is very different.
One friend is going to spend a relaxing week in Florida at a nice hotel, doing some leisurely shopping in the mornings while hitting up the beach in the afternoons. It sounds great.
Your second friend has been researching for weeks about an adventurous trip to the mountains of New Zealand to find an endangered blue orchid that only flowers one weekend per year. The mountains can only be reached by traveling for three days through the jungle on horseback, a journey that requires you to navigate a rushing river, traverse an active volcano, and spend a night with a tribe of natives who are famous for singing in their sleep.
You have two choices here: Florida or New Zealand. A vacation at a nice hotel in Florida would be easy, safe, and relaxing – which is what you need. But the vacation in New Zealand, while more dangerous, has huge potential to become a memory you would never forget. Taking on risk, it seems, may provide great reward, especially if (to go along with our story) solid research is done beforehand.
Good Risk in Peer to Peer Lending
In peer to peer lending, some of the loans are more like the first vacation, and some are more like the second. This is because these platforms offer loans to a variety of qualified borrowers, and some borrowers are safer than others. For the riskier loans (like loans repaid over 5 years), Prosper and Lending Club give out a lower loan grade and a higher interest rate. The great thing is that lenders like you and me can make a great return from these loans. Anytime you see a peer to peer lender who is getting over 10% returns, you can be sure they have some lower grade loans in their account.
If you go to your account page on either platform and click Browse Listings (Prosper) or Browse Notes (Lending Club), a long list of available loans will appear on your screen. These loans have been assigned different grades (and colors to match). Some loans are given an A rating. Others are given a C rating. If you click on each loan, you’ll see that A-grade loans give you a lower percentage than the other grades, maybe only 6%. But D-grade loans give you a larger return: maybe 17%. By taking on some higher risk, we can possibly increase the return on our investment.
Filtering Exercise – Adding Low-Grade Loans
Let’s do an exercise on the Lending Club platform. We will set up a filter that shows how investing in lower grade historically gives us better returns than investing in higher grade loans (reminder: these ROI numbers are probably inflated).
Step 1. Go back to NickelSteamroller.com and click on Return Forecaster.
Step 2. Set up two of the same filters we used in part 2 (Set both the Inquiries In The Last 6 Months and Public Records On File filters to zero). Now go to the top filter labeled Loan Grade (it’s the top one because of how important it is). Check only the boxes for A, B, & C grade loans - these are the loans with the least amount of risk on Lending Club. Click the little filter icon (the circling arrows). The historical ROI is 7.57% for these loans.
Step 3. Now click Check All on the loan grades section to select the entire set (A-G). Hit filter and watch the ROI climb a full point to 8.5%. As you can see, when we have a diversity of loan grades in our accounts the historical return can really grow.
Step 4. Let’s look at what would happen if we were invested in all the riskiest grades on Lending Club. Go to Loan Grades and select only D, E, F, & G. Hit filter. The historical ROI climbs to 11.08% – 3.5% higher than the safest loans.
Compound Interest: 7% vs 11%
Do you know the difference 4% growth makes? Over 30 years, $10,000 with 7% growth would end with $76,000. Growth of 11%, on the other hand, would return $229,000. This is why many lenders invest in lower grade loans. Historically, their returns have been really outstanding, and it offers them the chance to really grow their investment.
Low-Grade Loans: What are the dangers?
It is important to state that low-grade loans are issued to borrowers with the poorest credit history and least financial stability. These loans are more likely to default than any others. As a result, some people actually prefer sticking with less risky loans like those given an A grade. After all, you still get a great 6-8% interest rate, which is way better than your local savings account. Additionally, some evidence shows that these higher quality loans are more likely to endure stress that our country experiences, such as increases in national unemployment.
Some people simply cannot tolerate the risk of low grade loans. For instance, if you are a peer to peer lender nearing retirement and you cannot risk the possibility of losing your investment, you should probably focus on the highest grade loans, even if it means you will earn a smaller return.
Others do the opposite, investing only in low grade loans. This has been my strategy (see my portfolio from 2013Q1). I am younger and feel comfortable enough to take on that risk, especially after filtering the loan pools beforehand. This has resulted in me currently earning a much higher ROI than most lenders: over 15% with Lending Club and Prosper. I do not, however, suggest this approach for everyone. For most people, especially those starting out, it’s optimal to have an assortment of different loan grades so that you achieve a balance of stability and increased returns.
In part 4 we take this filter and split it to find more historical loans.
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