Most people think they understand how interest works. You invest $100 at 10% then your annual interest payment is $10 a year. If you are investing for a fixed term, say three years, that will mean $30 in total interest payments. Simple math.
But with p2p lending it is different. This same $100 invested in a 36-month p2p loan at 10% will get you far less interest than $30. If we compare apples to apples and assume no service fees then this $100 investment will net you around $16.15 in interest, close to half the interest from the previous example. What gives?
P2P Loans Are Amortized
Are you really getting just over 5% or so annually on your money? No. The reason the total interest is less is because you are investing in a fully amortized loan. What this means is that with each payment you are being paid back some principal as well as interest.
Let’s continue our example to demonstrate. The monthly payment for your $100 loan at 10% is $3.23. Given a standard amortization schedule the first payment is split into $2.39 of principal and $0.83 of interest. So, your $100 investment has been paid down by $2.39 and the principal balance is now $97.61. S0, next month you will not receive interest on $100, you will receive interest on $97.61. Herein lies the big difference with amortized loans.
Below is the full amortization schedule for a $100 loan at 10%. Now, keep in mind I am ignoring service fees in this example – in reality at Lending Club and Prosper a 1% service fee is deducted with each payment.
I hope this is clear for everyone. I have seen many new investors get confused about interest payments in p2p lending. Let me know if you have any questions or comments.
| Payment | Amount | Principal | Interest | Balance |
|---|---|---|---|---|
| 1 | $3.23 | $2.39 | $0.83 | $97.61 |
| 2 | $3.23 | $2.41 | $0.81 | $95.19 |
| 3 | $3.23 | $2.43 | $0.79 | $92.76 |
| 4 | $3.23 | $2.45 | $0.77 | $90.31 |
| 5 | $3.23 | $2.47 | $0.75 | $87.83 |
| 6 | $3.23 | $2.49 | $0.73 | $85.34 |
| 7 | $3.23 | $2.52 | $0.71 | $82.82 |
| 8 | $3.23 | $2.54 | $0.69 | $80.29 |
| 9 | $3.23 | $2.56 | $0.67 | $77.73 |
| 10 | $3.23 | $2.58 | $0.65 | $75.15 |
| 11 | $3.23 | $2.60 | $0.63 | $72.55 |
| 12 | $3.23 | $2.62 | $0.60 | $69.93 |
| 13 | $3.23 | $2.64 | $0.58 | $67.28 |
| 14 | $3.23 | $2.67 | $0.56 | $64.62 |
| 15 | $3.23 | $2.69 | $0.54 | $61.93 |
| 16 | $3.23 | $2.71 | $0.52 | $59.22 |
| 17 | $3.23 | $2.73 | $0.49 | $56.48 |
| 18 | $3.23 | $2.76 | $0.47 | $53.73 |
| 19 | $3.23 | $2.78 | $0.45 | $50.95 |
| 20 | $3.23 | $2.80 | $0.42 | $48.15 |
| 21 | $3.23 | $2.83 | $0.40 | $45.32 |
| 22 | $3.23 | $2.85 | $0.38 | $42.47 |
| 23 | $3.23 | $2.87 | $0.35 | $39.60 |
| 24 | $3.23 | $2.90 | $0.33 | $36.70 |
| 25 | $3.23 | $2.92 | $0.31 | $33.78 |
| 26 | $3.23 | $2.95 | $0.28 | $30.84 |
| 27 | $3.23 | $2.97 | $0.26 | $27.87 |
| 28 | $3.23 | $2.99 | $0.23 | $24.87 |
| 29 | $3.23 | $3.02 | $0.21 | $21.85 |
| 30 | $3.23 | $3.04 | $0.18 | $18.81 |
| 31 | $3.23 | $3.07 | $0.16 | $15.74 |
| 32 | $3.23 | $3.10 | $0.13 | $12.64 |
| 33 | $3.23 | $3.12 | $0.11 | $9.52 |
| 34 | $3.23 | $3.15 | $0.08 | $6.37 |
| 35 | $3.23 | $3.17 | $0.05 | $3.20 |
| 36 | $3.23 | $3.20 | $0.03 | $0.00 |
| Total Interest | $16.15 |
Which leads to the fact that most of the money you get paid every month is your own money from the initial investment.
This is another reason to keep reinvesting your payments. If you reinvested the entire payment, then you will have $100.83 earning a return rather than just $97.61. Under this scenario, you run into one of the greatest inventions ever–compound interest! Of course, this follows your assumption of no service fees, that you can actually invest $3.23 (as opposed to the minimum $25 increments), and no lags in time from finding a Note that matches your criteria, waiting for the Note to be fully funded, and then waiting for the Note to originate. But all those caveats aside…compound interest!
This is why we need LC and Prosper to post our weighted average yield to maturity, right beside our weighted average interest rate. This way at any given time we could run the amortization calculator and determine interest payments going forward!
I agree that a weighted average yield to maturity would be a far more useful number than just the interest rate. Better still, they could include both so we can see the impact of our newer investments.
Hi Peter – realize you’re teaching a 101 level class here, but perhaps important for the more advanced to see that LC charges a service fee of 1% of each payment – whereas Prosper does an annual 1% of outstanding principal. This, naturally, has implications to early payoffs at LC – as, essentially, investors are charged a 1% “pre-payment” fee whenever borrowers pay off their loans early. Don’t think many people see that fee for what it really is (or realize the implications)..
Peer-lend is correct. As has been pointed out on this board in past discussions, this 1% of each payment fee that Lending Club charges will wipe out most of the interest we receive when super early pre-payment occurs, for example, within the first 2 months.
In fact, in the case of super low interest loans (e.g A1-A3 notes), this 1% Lending Club fee wipes out ALL the interest & even takes a small bite out of our principal on first month super early pre-payments. I don’tr personally invest in those categories, but the point remains valid. Please feel free not to take my word & run the numbers for yourself. You’ll see that this is correct.
Granted that super early pre-payments don’t occur that often, In my almost 3 years at Lending Club I’ve had 183 early payments in my regular account. Enough of these have been super early pre-payments for me to have noticed & that’s why I’m going on & on about this here.
As Peer-Lend alluded to, Lending Club doesn’t charge a pre-payment penalty to its borrowers………………..it charges that penalty to us, the LENDERS! This is beyond unfair. It’s clear that Prosper is a helluva lot more “lender friendly” with the way the service fee is assessed.
Thanks for bringing this up. I don’t use LC yet, but I have been looking at them more and more as my idle cash continues to grow at Prosper. I will keep this in mind as I evaluate LC’s program.
Jason
Interestingly enough, when I used a Python script to run the calculations for me on various amounts of starting cash and rates, Prosper ALWAYS charges more total interest on loans that come to full term. So, LC is better for loans that don’t get paid back early, while Prosper is better if you have an exceptional amount of loans that do. I use both platforms in equal amounts for added diversity so you can rest assured that this is an objective analysis.
Peer-Lend, is the service fee on either (a) the interest portion only paid monthly or (b) interest and principal amount paid monthly?
I think I am going to do a separate blog post on this because it is a bit ridiculous that investors can lose money sometimes on a prepayment. I have talked with LC about this a couple of times and it is not high on the priority list. They don’t make it obvious to investors because they only show the service fee in the Account Activity section, you don’t see it in the Payment History. If it was displayed there investors would have been up in arms about this years ago.
I’ve only been with Lending Club for about 10 weeks and I’ve already had 2 full pre-payments out of ~180 loans. Lost money on both of them since I’m in a FolioFN-only state and have to pay a small premium on each note I buy in addition to the fee charged by LC…
I know this is an older article, but as a new-ish investor in Lending Club, I appreciate understanding more about how the interest accumulates, as it wasn’t really making sense before reading this.
I’m wondering if there is some equation I could stick in my Savings Goals spreadsheet to factor in for the amortization? Or would I have to know the weighted average yield to maturity?
I don’t need my spreadsheet to be super accurate, but I’d like it to give me a general idea of what interest I could expect to earn, if all of the loans I’ve invested in are paid back in full.
Thanks for any ideas about how to write that equation!
Hi Susanna,
There are plenty of online amortization calculators. They are mostly used for calculating mortgage payments but I have used them plenty of times for working out payments on my own p2p loans.
To see your own payments you need to enter in the amount you have invested, the interest rate and loan term. This will give you a rough idea of the principal and interest payments you can expect.
Use a calculator like this one here:
http://www.calculator.net/amortization-calculator.html
We should all continue to highlight this. I sent them an email complaining about this over 2 years ago & again when Rob Garcia was still around in early 2011.
Whatever. The most I lose is 1% (and only if they pay off the loan the same day it is issued). Most of the time prepayments have occurred, I’ve lost something like a nickel. Get your priorities straight, people!
Bryce………..You have a lot of gall coming here, & suggesting that other people (who may know a helluva lot more than you), get our priorities straight.
This Lending Club 1% fee on super early payments issue isn’t about whether you’re ok about losing a nickel or not, or whether you’re cool with losing the occasional 1% even though you’re actually the one lending the money. This is about whether the policy at LC is fair. This is about whether the policy at LC makes sense. It’s not all about you, believe it or not.
I think it’s rather presumptuous of you to attempt to frame this issue as if it should be a non-issue for others,………………… when it clearly isn’t, as evidenced by the preponderance of comments in this & other past threads, both on this site & elsewhere.
The prepayment I had this week on a slightly “used” loan I picked up from FolioFN… I lost 1.6% of my investment, which I think was 39 cents on the loan. I never received a single other payment on it so there was no interest to offset that loss. 39 cents does not matter in my day-to-day life, but on principle it does seem pretty lousy that an investor would ever be penalized by investing in a loan that was fully paid back.
Granted I am in a bad mood because I just had a third note fail payment in four days… which is coincidentally 1.6% of my total notes!
You’re right of course. There should never be a scenario where we as the lenders lose a single penny because of a super early repayment.
Dan, You have a lot of gall coming here, & suggesting that other people should do what YOU say. “We should all continue to highlight this.”
Larry………..For starters, I wasn’t addressing you. Also, I wasn’t suggesting that you or anyone else do what I say. I’m telling Bryce that he doesn’t speak for me……………nor from the preponderance of responses, does he appear to speak for the concerns of others here. So if you feel like you need to stick your nose into this……………..at least get what I said correct.
Come on Larry, can’t we all just get along? 🙂
Or are you still annoyed at our little exchange last week. If so, I apologize for calling you two dimensional or something.
Gentlemen, we can certainly have differing opinions on this without saying to each other what we should or shouldn’t do. As an investor I agree with Bryce. It makes such a small difference in the overall returns that for me personally it is a non-issue. But when I put my industry analyst hat on I can see that, even though it is a small thing, it is something that is not fair to the investor. As I said I will be highlighting this in a future post.
Peter……….Also the assumption seems to be that we are talking about $25 notes. As the note size increases, it becomes less of an insignificant issue. ”
Totally off topic…………..When you do your “update” & name change for this site, if possible, could you introduce an “edit” button, so that we can edit our own posts (e.g. the one Fivecentnickel has). Also do something about the inability we currently have to “reply” to “replies” past 3 or 4 comments. Right now it’s sometimes tough to figure out who is addressing whom &/or in regards to what because your setup doesn’t allow for a direct reply.
The most – you’ll have to forgive me – “interesting” part about LC’s 1% of each payment fee is that it’s applied to both returned principal and any earned interest.
While I can see why super-early pre-payment loss would not be an issue for smaller investors (though I do wonder whether people who count on a “nickel-collection” model understand the problem of losing even a single nickel) what I think you’ve all missed is perhaps what this edge-case brings to light:
Prosper charges what is essentially an AUM fee, applied only to principal, whereas LendingClub’s taking a bite out of your interest, too – essentially free-riding you…
Rationally, I prefer Prosper’s principal-fee approach, as an investor in their notes. Rationally, I’d prefer LC’s approach if I were an investor in LC itself – rather than it’s notes – though, if I put on my analyst hat, I’d ask: “What happens when the customers find out?”
I mean, LC’s fee structure looks great, when viewed in the incentive alignment/”we get paid when you do” sort of populist PR angle, but, if you adjust the prism, the photons start forming a new and curious pattern.
Anyway – nice discourse, here, as always. Thank you.
Peer-Lend………….I’m well aware of your argument & concur in principle. It is just a helluva lot easier to argue the early payment angle. I fear that I am not a good enough writer to even attempt to argue that larger argument in this room without a collective tuning out from the audience. 🙂
Oh & the answer to your question is, nothing. The reaction by the vast majority of lenders if & when they find out will be nothing. But I know that you know that.
I recall we had a disagreement or two in the past but it is nice to read your comments here again.
A model loan scenario – with fees included – should show a declining 36 month curve for Prosper’s fees (which are principal dependent) and a flat line of 1% per month (of every payment, principal+interest) for 36 months for LendingClub’s fees. That’s the easy way.
So, you can see on the early part of LC’s curve (flatline) the pre-payment penalty issue – and then also see why it’s not an issue at Prosper – and then compare the lifetime fees.
Whether people will care when they see it is, as you point out, another conversation. 🙂
I have started doing some research on this and the way you have stated it above is exactly where I am going with it. As Dan said, it is not easy to write about this in an engaging way but I will do my best. Hopefully I will get something out in the next week or so.
wow that 1% fee comes up to be a cost of $1.16 over the life of the loan. That’s a pretty substantial chunk of the earned interest.
I’m generally not a fan of prepayment penalties, but I think in this case if a person wants to pay off a loan that there should be a minimum payment that covers the entire principal of the all investors and the amount of time the money has been tied up for the investors at the interest rate of the Note. This way, if the person wishes to pay off the loan in the first month it would be all the principal + interest for the first month (regardless of whether they pay it off completely in the first week of the loan or the third). This should be done for however many months it takes until the lenders will not lose any money if the loan were paid off early. Sorry, but I’m not going to do any math here since I’m not currently on LC.
Either that, or every loan has a similar prepayment penalty for, say, the first 3 months…(again not doing any math because I don’t care enough)…
Or LC should eat the cost.
I wonder, though, if the fees are really that much different. I’ll admit that I don’t completely understand how they work. But, if the Prosper loans are a flat amount based on principle, and you reinvest any prepayments, wouldn’t you still be paying the same amount in fees?
Hi Shane, Good to hear from you. Overall I think the fees are pretty much the same in the end but with Lending Club fees hitting early payments the most and then Prosper hitting loans held until maturity the most.
Hi Peter,
great post. i actually didn’t consider the fact that the loans were amortized. I was one of the blissfully ignorant people who thought I’d be getting 13% a years on the $1000 I invested..lol..thanks for bringing me back down to earth.
Also I’ve read many of your other posts.. super helpful! Thank you.
You’re welcome. That is why you need to reinvest regularly. If you don’t reinvest then you will effectively be getting half the stated interest rate as your return (assuming no defaults).
I really hope that this is not a completely dead blog post. I’m currently using LC, and have been for a few months. I was really concerned reading this as I have had a couple full pays within the first couple of months already. Upon looking further into each of the notes, they took their 1% fee on the normal monthly payments, but on the full payment there was no 1% taken. With that I have not lost anything, may of only made .20 on the note, but no loss.
Hopefully this is not terribly old news and is of some help for those of you out there using LC.
Hi Sean,
This is a problem that many long time investors have experienced. It used to be worse – you could actually lose money when one of your A or B grade loans paid on first payment. But they have fixed that now. Prepayments are a problem though and it is something that we have come to live with on a small percentage of the portfolio.