One of the main concerns people have in this investment is its average default rate, which means, the rate at which people fail to pay back these loans. This is a really valid issue considering the investor takes the full brunt of the loss when a borrower defaults. Risks like a platform bankruptcy or new regulatory burdens are important to keep in mind, but nothing has a more direct and negative impact upon our investment’s overall return than the rate at which our borrowers default on their loans.
So people often rightly ask: “What is the default rate at Lending Club or Prosper?” Today we will answer that question in full, starting with a look at Lending Club’s historical loan performance, and finishing with a look at Prosper as well.
Historical Default Rates at Lending Club
Instead of trying to calculate the default rate ourselves, the always-helpful statistics site NickelSteamroller (NSR) has actually done all the heavy lifting for us. If we visit NSR’s Lending Club backtester tool and simply click the blue filter button, we can scroll down and see Lending Club’s loss rate (default rate) by year (indicated by the vertical arrow):
As you can see, the default rate they calculate (methodology) has actually changed a lot over Lending Club’s eight years of operation. Taking a macro view of this performance, there are some projections we can make about where the default rate is today and how it has changed over time.
Lending Club’s current default rate: about 5%
For 2010, you can see I’ve underlined a few key items. The first thing to notice is the fact that 100% of 2010’s 3-year loans have completed, having either defaulted or been paid back — over nine thousand loans in all. And the loss rate for this set of loans is 5%.
In short, the default rate for Lending Club’s most recent year of completed loans is 5%, and I feel this figure is a reasonable expectation going forward, as I’ll demonstrate in the following paragraphs.
We can ignore default rates for 2007 through 2008
Some might highlight the default rates for 2007/08, citing these as an indication for how reckless this investment is. However, just 600 loans were issued in 2007, not even enough to be statistically significant. Furthermore, Lending Club’s 2,400 loans in 2008 were issued under the company’s earliest credit model, and happened during the greatest economic downturn since the Great Depression – not really representative of how things usually are nationwide.
A fairer critique of default rates being 5% might be the 7.4% loss rate of 2009. However, the main economic factor that impacts peer to peer loan repayment rates is the national unemployment rate, and as you can see in the chart below, the Great Recession actually caused unemployment to peak in 2009, not 2008, which jives with studies showing the recession was not finished until mid 2009 (NBER.org).
This goes to show that Lending Club’s 2010 loans, with a default rate of 5%, are the first completed year we have of peer to peer lending loss rates during a somewhat normal US economic cycle.
Lending Club’s Default Rate Since 2010
But just because Lending Club managed a 5% default rate for a single year is no guarantee they will perform similarly in the future. That said, I think we can demonstrate future years acting similarly if we look at performance since then, and a good place to do that is by examining the chart below (included in Lending Club’s recent S-1 filing with the SEC). Even though 2007-2010 are the only completed years we have, this chart reveals the cumulative loss rates for years that have yet to complete:
[Note: Maybe you’ve noticed the default rates on this chart being higher than the data from NSR. For those interested, the chart in the SEC filing is more focused on simply highlighting Lending Club’s underwriting quality, so it finds the default rate by taking total lost principal, removing late fee earnings, and dividing this by the total issued principal (hat tip to Michael @ NSR for figuring this out).]
The point in showing the SEC-filed chart of vintage curves is to compare the default rate of 2010’s completed year to the remaining loan vintages that have yet to complete. And as we can see in the graph above, the default rate for 2011 actually improved over 2010, and will likely finalize around 4.5%.
In 2012, Lending Club Moved to 700-FICO Borrowers
From here we would expect default rates of 2012, 2013, & 2014 to slowly improve year by year as the economic woes of 2008 fall farther and farther behind. But they don’t. In 2012, the management at Lending Club made a change that would impact their default rate for the years going forward: they lowered their average borrower FICO score and increased their average interest rate. In 2011 the average borrower at Lending Club had a FICO of 716 and received an average interest rate of 10.8%. In contrast, borrowers in 2012 had an average FICO of 703 and received an interest rate of 12.98%, over a 2% increase. See the change in this chart at NSR:
This slight notch down the credit spectrum resulted in a new default trend, causing 2012’s rate to actually curve above the previous two years:
I actually think decreasing the average FICO and increasing interest rates was a brilliant move on Lending Club’s part. I think they saw the economic situation improving from 2008, and realized they had an opportunity to (1) match the tolerable default rate of 2010 while (2) actually increasing the average yield for their investors. I think they saw the chance to further solidify their investor base, and they took it.
Lending Club Default Rates Today? Still About 5%
Just like 2012, the average FICO score in late 2014 remains around 700, at least for their public data. Furthermore, as seen in the 2013 curve above, Lending Club’s default rate continues to get better, perhaps a combination of improved underwriting and a consistently lower unemployment rate. It looks like the 5.8% default rate of 2012 will be improved upon year-over-year, perhaps landing near 5% for loans issued in 2013.
Since 2012, the past three years have seen over 200,000 loans issued with an average interest rate of around 13%. Minus this 5% default rate and 1% in fees, this estimates most investors experiencing an average return of 7% on a seasoned portfolio (13-6=7), an estimate placed right in the middle of the 5-9% expected investor return cited by Lending Club over the years.
Default Rates at Prosper Marketplace
How about Prosper Marketplace? This is a lot trickier since Prosper has changed their average borrower a few different times since the company’s inception. Here is a breakdown of their default rate by year:
Unfortunately, this data is not really that helpful in talking about where Prosper is today. Similar to Lending Club, their most recent completed year is 2010. However, the loans they were issuing back then were a far different animal than those they are issuing today: 2010 loans with 19% interest rates vs. 2014 loans with 13% interest rates.
Orchard Platform showed this distinction within Prosper’s different years in their recent savvy post showing the cumulative delinquency rate by vintage:
Again, we see here that Prosper’s 2013 and 2014 vintages are looking dramatically different than their previous years. As a result, we’re going to have to look somewhere else to guess their default rate.
Prosper changed tack in 2013, likely new default rate is 5%.
That “somewhere else” is Lending Club. Here is the 2013 and 2014 data for 3-year loans at Lending Club and Prosper side-by-side (further courtesy of NSR):
Prosper changed their approach to match that of Lending Club; they currently issue loans to borrowers with an average FICO of 700 as well (Lend Academy). And their average interest and default rates for 2014 almost exactly match up, with a current ROI that is 8-hundredths of a percent apart.
As a result, I would wager that Prosper’s current issued loans will have an almost similar default rate as the one projected for Lending Club: 5%.
What About 5-Year Loans? An Exercise in Speculation
Lending Club issued its first 5-year loan on May 14, 2010 to somebody in Portland (loan #516401). We are still seven months from the first batch of these 5-year loans completing, and many of us in the peer to peer lending world are awaiting these final results with baited breath.
Until then, we can only guess the default rate using the data that is currently available to us. Here is the breakdown of 5-year loans by vintage from NSR:
I’ve highlighted the default rates for 2010-2012 because I feel these tell a similar story as the 3-year loans. You can see Lending Club issued an average interest rate in 2010 of 14%. But in 2011 they lowered their FICO standard to 700 and increased interest rates, bringing them up to the 18% figure that they’re at today. Considering the curve for these 2010 loans is fully seasoned (see SEC data on the right [different loss rates]), I assume the default rate will only go up a point or so in the coming year. So it’s possible these early 5-year loans will have a default rate of around 8%.
However, the 2012 vintage are riskier loans than 2010 (interest rates 18% vs 14%), so they are going to have to climb a steeper hill. As a result, I would not be surprised if these 5-year loans cross a default rate of 10-11% by the time they complete. That said, I think the 2012 5-year vintage will likely possess a higher default rate than those that follow, as Lending Club’s borrower standards for 5-year loans (and likely their underwriting as well) have improved in the past two years, all within a more favorable national employment climate.
It might very well be normal in peer to peer lending that, in five years time, 36-month personal loans will be known for 5% default rates, and 60-month personal loans will be known for 10% default rates.
These Default Rates Tell a Remarkable Story
In the end, what I love about all these charts is how they show this new investment evolving year by year. If there’s anyone who pays closer attention to default rates than investors, it is the teams who manage these platforms.
Indeed, the default rate data shows Lending Club’s management obviously grappling with the ugliness of the Great Recession around the time their company began. We have them positively recovering from this drama in 2010, and then intentionally pivoting, increasing investor yields in 2011. Finally, we have them discovering how well this works in 2012, this recipe of FICO/interest-rate keeping them the industry leader that they are today, issuing $1B in loans per quarter, on track for a successful IPO in 2014.
The data also gives Prosper’s story: their different approaches to borrower standards over the past five years, their average interest rate in all sorts of places. We have the new management team in 2013 coming to terms with the fact that Lending Club’s 700-FICO 13%-rate loan is likely the best way to thrive in this industry, a tack that has obviously worked very well for them. They have already issued 3X the 3-year loans in 2014 than they did in all of 2013.
Over everything, I see an industry doing its best to figure out this beautiful new thing called peer to peer lending. I see refined underwriting algorithms and mailed borrower marketing, encouraged investor capital and purpose-built technology all repositioning itself over and over for the past eight years until they arrive at the stable place they hold today. I see analysis and sweat and reanalysis in these charts, and in the end I see it culminating into one of the most simple and creative investments our country has ever seen.
[image credit: Richard Taylor “Sunken boat at sunset” CC-BY 2.0]