One of the biggest concerns people have with peer to peer lending is default rates – basically, how often these loans are not paid back. It’s a good question. After all, these are unsecured loans we are helping issue, meaning the loans are not tied to any collateral like a house or car. If the borrower cannot repay their loan, there is no real penalty they receive (besides a nasty mark on their credit), so a sizable number of these loans eventually do default.
Today we will answer this important question: what is the default rate in peer to peer lending?
An Annual Default Rate
When people ask, “How many of these peer to peer loans eventually default?”, they are often just asking how much of the investment is lost to non-paying borrowers. “How many?” versus “How much?” is a different question altogether; it is the difference between the number of loans and the total investment (principle).
We care a lot more about the principle. For example, even though 12% of Lending Club’s loans may eventually end in default, these bad loans might drop our overall return by only 3%. Interesting! Why this difference?
The answer lies in the way peer to peer lending operates. Peer to peer lending is a rolling continuous investment. After we first open an account, borrower payments will begin to collect as available cash, cash we can then use to invest in additional loans. Eventually there will be a lot of variety within our account. Some loans will be older with more defaults, and some will be younger with fewer defaults. Furthermore, when borrowers default on younger newly issued loans, we lose a lot more of our investment than we would if the loans were older and borrowers had already paid back much of the principle.
Therefore, the best way to think of defaults is how much principle, on average, is lost per year. This is the annual rate of default as highlighted in the next section, and it is a different number altogether from the eventual percentage of principle lost when loans are completed, not to mention the eventual percentage of loans that default. However, all three numbers are interesting to look at, so let’s take a moment to do that.
Lending Club & Prosper Default Rates
In the graphic on the right, you can see three different numbers for both platforms. The top number is the annual rate of default. This is the yearly percentage of principle (invested money) lost to defaults since the platforms began. Underneath is the eventual default rate for Lending Club and Prosper’s completed loans. The third number is the historical percentage of completed loans that have ended in default.
The Default Rate in a Nutshell
The most important number in this graphic is the annual default rate, how much of the average investment is lost each year to non-paying borrowers. For Lending Club, it’s 3.0% and for Prosper it is 8.6%. Lending Club continues to highlight this 3.0% default rate throughout their site, for example at their About Net Annualized Return page or in their FAQ. Prosper’s default rate of 8.6% is higher, largely because their loans have historically had higher interest and risk than Lending Club.
Let’s look at how I discovered each of these numbers.
Our Baseline: Annual Rates of Default
This was probably the easiest to discover. I simply went to NickelSteamroller’s Return Forecaster and backtested the historical rate of return for all Lending Club loans issued from 2009 until now (with loss factors found here). Note: I set an Issued Date of January 2009 for Lending Club (and July 2009 for Prosper) because this is when the platforms launched with approval from the SEC.
Lending Club’s annual default rate:
Trying to find Prosper’s annual default rate was done the same way, but through the Loan Analysis tool at Prosper-Stats.com. Both these tools do an excellent job at highlighting one of the big differences between Lending Club and Prosper. Lending Club has historically had much lower defaults than Prosper, a result of having stricter underwriting (660 minimum credit score to get a loan vs 640 for Prosper), though it seems like this may be changing (see the trend in this graphic).
Having a higher default rate has been the price Prosper has paid for offering substantially higher interest rates than Lending Club. HR-grade (high risk) loans at Prosper commonly have a 31% interest rate and a 20% default rate, while the riskiest Lending Club G-grade loans have a 25% interest rate with only a 10% default rate.
What is the Annual Default Rate for Completed Loans?
A different number comes up when we look at completed loans only, highlighting the percentage of principle that is eventually lost. For Lending Club, this is 7.7%, and for Prosper it is 6.2%. For the Lending Club number, I went again to the NickelSteamroller tool and checked the box for Process only completed loans (with the same loss factors and Issued Start Date as before).
Then I did the same thing for Prosper at Prosper-Stats (setting the date range from 2009-07-01 to 2010-07-24 to isolate their completed loans). It is interesting to point out how low the rate is for completed loans (6.28%) in comparison to the overall annual default rate (8.65%). In my opinion, Prosper’s default rate for its completed loans will probably climb in the coming year. More and more loans default over time, so Prosper’s completed loans should naturally have a higher default rate than uncompleted ones.
What Percent of P2P Loans Eventually Default?
Finally I examined what percentage of completed loans end in default. To get the previously mentioned figure for Lending Club and Prosper, I went to the NickelSteamroller Default Rate chart and averaged the rate of both platform’s completed months. Lending Club has eighteen months of completed history (Jan ’09 – June ’10) and Prosper has ten (Sept ’09 – June ’10). Note: I trimmed Prosper’s July/Aug 2009 since they seemed unrepresentative.
Averaging these completed months had 12.6% of Lending Club’s loans and 14.5% of Prosper’s loans eventually defaulting. See below: for loans solely issued in June 2010, about 14% of Lending Club’s defaulted compared to 16% of Prosper’s.
Interestingly, this data seems to say that 13% of peer to peer loans have historically failed to be paid in full, perhaps typical of unsecured 3-year loans anywhere.
Conclusion: Reinvest Those Returns
Hopefully all this talk of figures and percentages gives you a better picture for how defaults factor into investing at Lending Club and Prosper.
If there is any big lesson to take from all this data, it is the importance of reinvesting your returns. While the default rate for completed loans is high, the overall default rate is much more reasonable (7.7% versus 3.0% for Lending Club). Make sure to log into your account and invest any available cash that has built up, and you can be sure to keep your default rate at a much more tolerable level.
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[image credit: Richard Taylor "Sunken boat at sunset" CC-BY 2.0]