As promised earlier, I'm going to do some calculations to see just what kind of returns you can get from a Lending Club investment. I'm specifically going to consider three things: (1) The maximum return you could expect from an "average" investment. (2) How many loans you can have default before you break even or lose principal. (3) What the most realistic scenario would be based on my own portfolio and historical trends.
For the first question, I'm going to assume an investment of $1000 at an average rate of 12% interest. This assumes no reinvestment and no defaulted loans. An interest rate of 12% looks good, but remember this is a loan, not a certificate of deposit. That means the principal goes down each month therefore the amount you are getting paid interest on goes down as well. So over the course of 3 years, you would receive a total of $195.72 in interest payments, and the return of your $1000 investment. That is equivalent to a annual rate of return of about 6.5%. When you factor in that LC charges you 1% of each payment in processing fees(thats principal and interest), your actual return is $183.76 and APY of 6.13%. What this means is, if you can find a secure investment with a APY of 6.13% you are better off putting your money there than in a loan portfolio. But I bet you can't find that kind of return right now in the USA. Of course, this is a best case scenario. What if you had some loans default?
Adding loan defaults into the equation complicates things greatly, because how much interest you make and how much principle is returned depends on when the loan defaults. To simplify matters, I'm going to look at a worst case scenario in which all loan defaults happen before the first payment is ever made. Since $25 is the minimum you can contribute to any particular loan, I'll assume the original $1000 is divided into 40 loans for at $25 each. Also, I'll assume the loans that default do not affect the average interest rate. For beginning defaults you see:
| Loan Defaults | Return | APY | % default |
| 0 | $1,183 | 6.10% | 0.00% |
| 1 | $1,154 | 5.13% | 2.50% |
| 2 | $1,124 | 4.13% | 5.00% |
| 3 | $1,094 | 3.13% | 7.50% |
| 4 | $1,065 | 2.17% | 10.00% |
| 5 | $1,035 | 1.17% | 12.50% |
| 6 | $1,006 | 0.20% | 15.00% |
| 7 | $976 | -0.80% | 17.50% |
As the table shows, you can sustain up to a 15% default rate before losing principle. However, that would leave you with zero gains after 3 years. A better scenario is a less than 5% default rate. Keep in mind that this if all defaults happen at the beginning. You could have every loan in the portfolio default on the final payment and it would be like having 1 loan default in the beginning.
Finally, a closer look at my own portfolio and what kind of returns I expect. I'm continually reinvesting my returned principal and earned interest. In this manner I'm able to maintain the high rates of return given by the advertisements. My portfolio average right now is just about 14%, so after a 1% fee(on principal and interest) my actual returns should be closer to 12.8%(ideally). What kind of defaults do I expect? (In my dreams I see zero defaults, but reality isn't that nice). Adjusting for the weighting of my portfolio, my risk of default based on historical data should be :
| Loan Grade | Actual Portfolio make up | Average Grade Default Risk | Weighted Risk |
| A | 6.00% | 0.47% | 0.03% |
| B | 5.00% | 1.26% | 0.06% |
| C | 12.00% | 2.05% | 0.25% |
| D | 19.00% | 2.84% | 0.54% |
| E | 25.00% | 3.63% | 0.91% |
| F | 16.00% | 4.42% | 0.71% |
| G | 17.00% | 5.21% | 0.89% |
| Average Risk | 3.38% |
This compares favorably with the previous table. For a loan portfolio earning 14% average, we see that for every $1000 invested(without reinvestments):
| Loan Defaults | Return | APY | % default |
| 0 | $1,218 | 7.27% | 0.00% |
| 1 | $1,187 | 6.23% | 2.50% |
| 1.35 | $1,171 | 5.70% | 3.38% |
| 2 | $1,157 | 5.23% | 5.00% |
| 3 | $1,126 | 4.20% | 7.50% |
| 4 | $1,096 | 3.20% | 10.00% |
| 5 | $1,065 | 2.17% | 12.50% |
| 6 | $1,035 | 1.17% | 15.00% |
So an equivalent guaranteed investment would have to earn 5.70% APY before it would be a better investment than a loan portfolio. Obviously you can't have 1.35 defaults before the first loan payment, but as the loan base gets larger it should more closely resemble the historical data. Again, this data ignores reinvestment of returned principal and interest.
Here is the spreadsheet I used to calculate this data: Download loan_vs_cd_caculator.ods It's an Open Office document. In another six months I should have enough real world data to see how accurate the model is and what actual rates of return are.
P.S. One of my late loans paid up, so now I currently have 2 loans that are past 30 days due, which means a potential default rate of 0.9% right now. It's not technically default until 120 days past due, but any loan 30 days late is not something you can count on.
After following (but not investing) Prosper and LendingClub for a long time, this analysis and summary is exactly what I've been looking for this whole time.
Really solid. Thanks so much for the numbers and ods spreadsheet.
Posted by: Paul irish | January 04, 2009 at 09:10 AM
Excellent work. Any chance of updating your stats based on your own loans and re-examining the current stats posted by LC? Thanks!
Posted by: Mike | May 11, 2009 at 03:43 PM
Actually, you can download all of LC's data from their website. Just look under the statistics link on there homepage. Now there is actually enough data for it to be meaningful. However, for fun, I put up own results with LC in a new post. Sadly, not as good as I hoped, but I'm still optimistic about LC.
Posted by: Step3 | May 13, 2009 at 05:49 AM