I have been doing a bit of digging around the loan data for both Lending Club and Prosper the last couple of days. Like most p2p investors I am concerned about default rates. Not just my own but default rates for all p2p investors. If p2p lending is going to make it as a mainstream investment alternative we need the majority of p2p investors to be successful. Defaults are a big factor in determining that success.
Take a look at the simple spreadsheet above. I looked at all the loans from July 1, 2009 through June 30, 2010. I would like to go back further but Prosper relaunched in July 2009. Lending Club relaunched with their new underwriting criteria in October 2008, so the above table really does compare apples to apples. Keep in mind, though the median age of a loan in this analysis is just 10 months old.
As you can see there have already been a few charge-offs and there are many more loans that are seriously late. To get my estimated default rate I simply added all the charged off loans with those that are more than 30 days late. This is a somewhat artificial way of estimating the final default rate because not all late borrowers will default. Plus there will be new defaults among those loans that are current right now. But my guess is that after 10 months, most of the scammers have already defaulted and the remaining defaults will be those people who experience true financial difficulties.
P2P Lending Default Rates by Credit Grade
The table above shows the estimated default rates (using my formula of charge-offs + 31-120 days late) spread across the different credit grades. If nothing else this tells me that both Prosper and Lending Club have done a good job in rating the borrowers, as it is somewhat of a linear scale from best credit to worst credit as far as default rates go. One point to keep in mind is that both Lending Club and Prosper skew towards higher rated loans. For example in Lending Club there are 1,803 A grade loans in the 7/1/09 – 6/30/10 time period and only 157 F grade and just 69 G grade loans. The median loan rating for Lending Club is B and for Prosper is C.
The Final Default Rate
Now, my estimated default rate calculation could be easily understating or overstating the actual final default rate on these loans. But I am quite certain of this. The final default rate will be more than what Lending Club claims as the sub 3% default rate in place right now. While this 3% number is technically true, because Lending Club is growing so fast most loans haven’t had much of a chance to default. To demonstrate this, I analyzed the older loans from that period, those that were issued between 7/1/09 and 12/31/09 (the first half of the period in the spreadsheets above). The median loan age in that period is over 15 months and actual defaults moved to 4.77% (up from 2.75% for the whole year) for Lending Club and 6.10% (up from 3.99%) for Prosper. If I had to guess I would say a final default rate will end in the high single digits but clearly the default rate of 3% Lending Club claims is an underestimate (Prosper makes no claims as to estimated default rates).
[Update: It has been pointed out to me that Lending Club claim an annualized default rate of 3% which corresponds with my findings. With a 3% annual default rate, the total defaults on the life of the loans will be around 10%. Also, there is much more data on the lendstats.com web site where you can slice and dice both Prosper and Lending Club data.]
Obviously you can reduce your default rate dramatically by choosing higher grade loans as well as conducting in depth research on the loans you are interested in. As I pointed out in my post last week three successful Lending Club investors have very low default rates by having strict criteria when deciding which loans to invest in. Their final default rate will likely be far lower than the averages suggested here.
While default rates for the average investor will be higher than 3%, I am also confident that we will not return to the 39% default rate that we saw on the loans (now mature) from Prosper’s first two years of existence. There is much stricter underwriting today than in the early days for both Prosper and Lending Club. A mid to high single digit default rate will still leave the average investor with a decent return on their p2p lending investment.
Later Defaults Have Less of an Impact
One last point to make about defaults. The longer a loan goes without defaulting the better off you will be. For example, if you have invested $25 in a loan that defaults after 18 months you will not lose your entire $25 investment. You will have received principal and interest payments for 13 or 14 months, so your total loss will only be around $13 – $15 depending on the interest rate. So this will have less of an impact on your net annualized return.
I intend to keep a watch on this portfolio of loans from 2009-10. I will report back on the defaults (both actual and my estimated calculation) on a monthly basis to see how they are going. My goal here is to report the facts as they are. I believe that p2p lending is a great investment, but there is a risk of defaults. It is best if investors come in fully informed as to those risks and not be disappointed a year or two into their investment.