The Difference Between a Default and a Charge-off at Lending Club

If you have a well diversified p2p lending portfolio then defaults are annoying but they are unlikely to do too much harm. Regardless, we want to minimize them as much as possible.

But what is a default exactly? It has always been a little curious to me that defaults are treated differently at Lending Club and Prosper. At Lending Club a loan moves from late into default before it is charged off whereas at Prosper there is no intermediate category, notes just go from late to charged off.

Why is there this intermediate category at Lending Club? When I asked this question they provided this as an official response:

In general, a note goes into Default status when it is 121 or more days past due.  When a note is in Default status, Charge Off occurs no later than 150 days past due (i.e. No later than 30 days after the Default status is reached) when there is no reasonable expectation of sufficient payment to prevent the charge off.  However, bankruptcies may be charged off earlier based on date of bankruptcy notification.

Of course, this leaves more questions than answers and also leaves out an important piece of information. Defaults and charge-offs affect your account in different ways.

Defaults and Charge-offs Impact Your Account Differently

When a note moves to a status of default it will reduce your Net Annualized Return (NAR) but not your account balance. When a loan moves from default to charged-off the outstanding principal is removed from your account and your balance is adjusted accordingly. This two stage process can indeed take up to 30 days to complete although sometimes, particularly in the case of a bankruptcy, it can all happen on the same day.

If you have a relatively new account your NAR may be impacted dramatically by your first default. In my new Roth IRA account, where I invest in loan grades D-G, my first default sent my NAR down 2.26% whereas in my main taxable account that is nearly three years old a recent default sent my NAR down 0.07%. In both cases my account balance reduced by less than $25. This big difference is because the loss in a new account is so large compared with the total interest gained that is has a large percentage impact.

Of course, you can avoid defaults altogether if you sell loans on the trading platform as soon as they become late. But that is a post for another day.

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Marc
Apr. 24, 2012 7:23 am

Peter,

Thanks for covering this. I’m now recovering from my Charge Offs. It was frustrating trying to figure out when the stats Lending Club was reporting would fully reflect the damage done. As far as I’m concerned, as soon as a Note is Late, the money is gone (a shame the LC stats don’t show that for 150 days).

Danny S
Danny S
Apr. 24, 2012 7:28 am

I had an LC note which was in Grace Period go straight to Charged Off when BK was filed by the borrower. So can happen at any stage of the process.

White Coat Investor
Apr. 24, 2012 10:47 am

I avoid this problem by calculating my own return. I don’t trust LC and Prosper to do it properly anyway. They can’t even report their past returns accurately. Compare what they report to what you see on Lendstats.

Bryce M.
Bryce M.
Apr. 24, 2012 6:26 pm

So, then advertising that X% of loans are “in default” is shady in my opinion because that is just a transitory category. To reflect the true share of problem loans, one needs to look among loans that have finished their term and have charged off. But, 1% defaults sounds so much better.

Dan B
Dan B
Apr. 24, 2012 11:12 pm

Peter…………I feel like I might be missing something here. Are you (or is anyone else) in any way suggesting that there have been instances where a “defaulted” loan does not later get “charged off”?
Because if you are then that would be interesting & I’d love to see the evidence. If however you’re not suggesting any of the above, then I’m not quite sure why the distinction between the terms isn’t just academic.

Simon
Simon
Apr. 25, 2012 12:40 am

Hi Peter! I would really value reading something about how to look at loans once they’ve passed the LendStat filters we’ve been using. At what point do you let bad spelling effect your investments? What if they use emotional language? (IE: “I promise I won’t default!!!”) I would love to hear what things you look for when you find a loan that passes your LendStat filters.

Danny S
Danny S
Apr. 25, 2012 7:19 am

Simon… I’ll answer and I’m sure Peter will too.

For me… bad spelling, if its just one word, I can let slide. But if there are numerous spelling errors, or horrible grammar, I do filter those notes out. I have ZERO evidence those notes are riskier. But its an emotional thing for me… if a borrower cant take the time to properly spell check their loan request, I dont want to fund it.

I also filter out “emotional language” notes, especially people who “promise not to default” and then have some sort of late payment or other negative item in their credit history, even if its 60+ months ago. Again, zero evidence that such language makes a borrower riskier… but just the impression I get leaves me less willing to lend to such borrowers. I’d never use such language on a loan app with a bank or credit union, and I dont think its appropriate here either.

Danny S
Danny S
Apr. 25, 2012 7:21 am

Let me also add, I also filter out anyone who has a late payment or other negative item on their CR, but as part of the question/answers, writes they’ve either never been late, or dont know if they have.

If they dont have an excellent grip on their CR, that may make them less likely to care about it. Another “no evidence” filter I use.

On the other hand, if they have a plausible response on what happened, I usually dont filter out that borrower.

flyp52
flyp52
Apr. 25, 2012 10:45 am

I have had a loan come back to life from the Default state. I have a recollection that I even had a loan that got completely paid off just days after it got charged off – that looked a little suspicious. I should have written down the loan number.

Joe S
Joe S
Jan. 23, 2014 7:06 pm
Reply to  flyp52

Did you receive any money from the charged off loan that was paid off? Curious

Neal Smith
Neal Smith
Apr. 25, 2012 11:09 am

@Simon Maybe this is obvious, but if the word “bankruptcy” is used in the description I’ll pass. My very first prosper loss was on a listing where the borrower tried to explain a past chapter 13. A recent prosper listing said “I need thias loan to avoid bankruptcy”.

Brady
Brady
Apr. 25, 2012 6:44 pm

Here is my understanding:

Financially speaking a loan is defaulted the minute the contract terms aren’t met – so if a borrower misses a payment, they have defaulted on the loan. However, many loans, including these from LC, have provisions in the contract (see Lending Club’s borrower agreement item #6 Fees) where the borrower is first given a window of time to come back into compliance – a grace period, then different stages of lateness with charged penalties.

When this second chance window expires (see Lending Club’s borrower agreement item #7 Default and Termination), the lender formally claims the borrower is in breach of contract and declares an Event of Default. This term triggers the entire loan balance outstanding to be immediately due, no longer offering the payments to be made according to the payment schedule.

After this, if the lender then doesn’t believe there is commercial benefit on performing any more collections activities they begin to declare the loan bad debt and write-off.

https://www.lendingclub.com/info/loan-agreement.action

Mike
Mike
Apr. 25, 2012 6:49 pm

One spelling or grammatical error is grounds for me to eliminate the loan from my consideration. I also eliminate any loan that uses the words ‘financial freedom’ or ‘help’ in the title, or any language that implies desperation on the part of the borrower. I also eliminate any listing where the borrower keeps adding comments on a daily basis like “thanks for all who have contributed so far”, or “I promise to pay this loan off early”, or any similar type of comment.

Back on topic, Peter, are you suggesting that LC specifically designed these two categories to make their bad loan rate look better than it actually is? Is there a way to determine how many or what percentage of defaulted loans get back to current status?

Louis Lamoureux
Louis Lamoureux
Apr. 25, 2012 8:22 pm

Hi Simon,
I just passed on a loan that met my criteria, the loan title was “Help” and the description said, “God Loves Me”.
Red Alert Red Alert

I also pass on keywords like “miracle” “Bankruptcy” anything religious. I don’t have evidence, I just sleep better at night. I also skip anything medical related. Medical expenses are one of the biggest causes for bankruptcy, so if they are consolidating medical bills, or they mention they were out of work because of illness or surgery Skip.
Lou

Mike
Mike
Apr. 25, 2012 8:28 pm

@ Lou, Since God loves him, I’m sure he’ll fund the loan himself fully. Good point about medical expense loans. I have never invested in those for exactly the same reason you quote.

hopehickory
hopehickory
Apr. 26, 2012 10:55 am

I now have 2 out of 163 loans that are in collections. This is shocking to me because both of these borrowers made only 1 payment before starting to default. Neither of these had any blemishes on their record in terms of late payments, past defaults or bankruptcies. The only worry was that one was a B and the other was a D loan. If both of these become charge offs that will drop my APR from 12 to 7% I think. I can only assume more loans will default at time goes by. If the number of defaults increases I am going to have to reconsider investing any more money into this questionable investment vehicle.

Dan B
Dan B
Apr. 26, 2012 2:38 pm

Hopehickory………Unless the 2 loans you refer to are of a much higher dollar value than your other loans, I’m certain that your NAR or ROI will not go down by the 5% you suggested they would, if they were to both default. The drop will not be greater than 2% or I’ll eat a rodent! 🙂

Also keep in mind that the initial drop that occurs with the NAR number is not permanent. Barring a scenario where defaults happen on an ongoing basis, your return numbers will recover substantially over time.
Another thing to keep in mind is that 2 defaults so far out of 163 loans isn’t that many or that unusual……………..unless your overall portfolio is very young.

Brady
Brady
Apr. 26, 2012 9:14 pm

@Hopehickory

Try and sell the notes on FOLIOfn at a discount and move on. Why wait for the bottom to fall out, especially if you have so little faith in them? Worth a try.

hop hickory
hop hickory
Apr. 26, 2012 10:10 pm

Thanks for your input guys. I guess I don’t really have a handle as to how the APR is calculated. I was just subtracting the principle left on the loans from my gains. My portfolio is about 4 months old. As far as selling notes in Folio, I haven’t signed up yet but I thought you couldn’t sell notes that were sent to collections, which my two late loans were.

shu zhou
shu zhou
Mar. 1, 2014 6:54 pm

Hi, guys, thank you very much for all of your comments. I am new to the Lending club. I get so many informations from here than on the LC websites.

I have a specific question, which one is more safer investment between lending club and prosper ?

Shu

shu zhou
shu zhou
Mar. 2, 2014 12:49 pm
Reply to  Peter Renton

Hi, Peter,

Wonderful. Thank you for answering my questions, I watched some of your videos about LC and Prosper . I gained quite a bit from your experiences.

I feel i can put a bit more money to LC and prosper. thank you for your wonderful works. and I really appreciated for all your tips and informations.

your are clearly a leader expert on P2P. Bravo to you!!

Thomas shu

shu zhou
shu zhou
Mar. 2, 2014 2:46 pm

Hi, Peter:

I am jealous of your courages investing more risker grade loans like DE.F. I viewed your return for some quarters, and I have a question.

Since your return is about 10-13% in general, but the grade D.E.F have much higher yield than that because of subtracting the charge offs and defaults. why not just investing A.B.C grades and getting the very similar returns? why bother to invest more risker notes? as you stated the return will always close to standard deviation .

Thanks a lot , Peter.

Thomas

shu zhou
shu zhou
Mar. 2, 2014 6:08 pm
Reply to  Peter Renton

Thanks for your explanations. great points. When CD rate is so low, grade A rate for me is so impressive; however, there is no 100% for sure grade A will not be charged off either. I just opened an account for less than 10 days. I realize Lending club also has so many flaws , the money turnover rate is kind low: for example, you invest $1000 into your account , you will not be able to invest or use it at least 8-10 days (4days to ACH in , 4 days ACH out); even I invested into the notes, the money is just sitting there “in review” so, there are too many investors than borrowers; LC just hold my $1000 there doing nothing ; do you agree ? or LC uses my $1000 and invest somewhere for 6 days as ACH doesn’t need so long to clarify ? In summary, I am more worried about lending club than financial crisis .