It may seem like a bit of a mystery as to how interest rates are calculated but a lot of this information is readily available for borrowers.
Interest Rates at Lending Club
Lending Club is completely transparent when it comes to how they set rates. Everything a borrower would ever want to know is on Lending Club’s page titled Interest Rates and How We Set Them. So if you know your credit report intimately you should even be able to work out your interest rate in advance.
Here is a quick summary of how Lending Club determines borrower interest rates. All this information is publicly available at the link above.
- The Lending Club Base Rate
The base rate is the starting point in determining the interest rate for each loan. As of this writing the base interest rate at Lending Club is 5.05%. Now, no borrower can actually get that rate, this is just where their calculations begin. On top of that rate is added an adjustment for risk and volatility. There is a different adjustment rate for every loan grade from A1 to G5. This adjustment is added to the base rate to determine the final interest rate.
- FICO Score
Initially every borrower is assigned a loan grade from A1 through C5 depending on their credit score. Borrowers with FICO scores of 770 and above are an A1 down to scores of 660-663 who are assigned a C3. But this is just an initial loan grade – a borrower will likely be moved to a different grade based on the information described in the next two points.
- Loan amount limits
I wrote a detailed post last month about loan amount limits. Basically, each loan grade has an upper limit and if the borrower goes above that limit as determined by their loan grade (based on their FICO score) then they will be penalized. For example, a B2-grade borrower has a loan limit of $7,475. If this borrower wants a $15,000 loan they will drop four loan grades to a C1 and therefore pay a higher interest rate.
- Other Risk Modifiers
There are other risk modifiers that will also send borrowers down a grade. Number of recent credit inquiries, the length of credit history, number of open accounts (ideal is 6-21 open accounts), revolving credit utilization (ideal is 5-85%) and loan term (ideal is 36 months) are other items from a borrower’s credit report that will impact the loan grade.
Lending Club has done borrowers (and investors for that matter) a great service here by detailing the methodology they use to calculate interest rates.
Interest Rates at Prosper
Prosper does not make their interest rate calculations public but, like Lending Club, they have several pages on their website that explain a great deal about the process.
Prosper relies heavily on its almost six years of loan and payment history. Based on this history it has developed a model that it uses for predicting the likelihood a loan will go bad. The model uses two pieces of information: your credit score (Prosper uses Experian Scorex Plus) and their proprietary Prosper Score.
The Prosper Score is a number from 1-10 with 10 being the best (or lowest risk) and 1 being the worst (or highest risk). Based on data collected from more than 40,000 loans issued since 2006 Prosper has a good idea based on your credit data the likelihood that you will default. While it doesn’t share how much weight it gives to each piece of credit data we do know that number of inquiries, number of accounts, number of delinquencies, available credit and percentage utilization of that credit are important. Prosper also uses many other factors such as income, employment status and length of credit history.
Estimated Loss Rates
When Prosper has given you a score it now needs to assign a Prosper Rating (also called a loan grade). The rating is determined by what Prosper considers will be the estimated loss rate for a loan such as yours. These are annualized loss rates and they help determine the Prosper Rating given to each loan (as you can see in the chart above).
What they mean by loss rates is the expected amount of principal that is lost by investors on a portfolio of similar loans. Prosper looks at its rich database of loan history and determines that similar loans lost a certain amount of principal each year. Then, bingo, you have the loan rating. There is a table and more detailed explanation on Prosper’s Estimated Loss Rates page.
Now Prosper doesn’t share the exact formula that it uses to determine the Prosper Score but we can get some idea by looking at the loans on their platform with the same ratings. You start to see patterns. But of course, there are anomalies, such as self-employed borrowers. These people are penalized heavily (as I was when I took out a Prosper loan) regardless of credit score and other credit data. This is based on the Prosper loan history – self-employed borrowers have performed poorly historically.
All potential borrowers should spend some time trying to understand the process of setting interest rates at Lending Club and Prosper. By understanding some of the factors involved they can work to achieve the best interest rate possible when they apply for a loan.