Tuesday, September 04, 2012

Mrs. RT: Avoiding Early Pay-offs at Lending Club

Note: After a week long hiatus, we are back. Mrs. RT once again wanted to share her opinion. She has become quite a proponent of peer to peer lending. She can't resist talking about it at social gatherings.

Later this week, I will have some very exciting news to share with you. Stay tuned ...

The Panic of early pay-off

The presidential campaign is getting hotter and hotter these days. So, today’s topic is how bad political extremes are…. Oops! This is about peer to peer lending. Let me change the gear.

The other day, Mr. RT said that one of his loan at Lending Club was fully paid off. What!? No, we were supposed to keep on collecting interest for five years. Wasn't that the term of that loan? Did we lose money because of fees? I became a little panicked. “Calm down, Mrs. RT”, said Mr. RT. Then, I realized I was talking about losing 25 cent fee. It’s good to have analytical person as partner.

The Good and Bad feeling of early pay-off

That was how I found lenders could pay off early without pay-off penalty. This is good to know!
In our own situation, we paid off our mortgage before the loan term ended. Our interest was so low that it didn't make sense to hang on to the mortgage balance as it was not beneficial for the tax deduction anymore. Moreover, we can save future interest. That’s a great feeling to become loan free! So, I can imagine this borrower, who paid off our loan far in advance, must feel the same way I do.

However, it’s contradicting thought, I know, as lender, I’m looking for more “reliable” loans, so that I can collect money during the loan term and count on estimated return. Hmm..., that’s how all the banks and mortgage lenders are thinking…? I feel I am becoming greedy like them.

Avoiding early pay-off

If I read the loan descriptions like these for 3 year loan, there’s no way I will lend money to those “responsible” borrowers:
“I have a great job, make a 6 figure salary and can pay this back in about a year; if it came down to it a few months,”
“I can even afford to pay off this loan in less than 2 years if necessary.”
Sorry, you are too good for me! I became curious to know what characteristics people who paid off early have in common.

Imitating Mr. RT

I downloaded historical loan data from Lending Club site. I limited my analysis to the loans issued in 2012 and that were fully paid off. There were 536 loans issued in 2012 that were already fully paid off as per the data available on September 3rd. Because there are only two loan terms, 36 months and 60 months, these borrowers are way ahead of the schedule to pay back.

Further, I excluded partially funded loans. In the end, there were 454 loans that were paid off and issued this year. What I found interesting and think it would be good for me to consider selecting loans are following:
  • 398 loans or 87.7% of loans that were paid off early were for amount $20,000 and less.
  • 364 such loans or 80.2% of loans were issued to borrowers with credit grade from A to C.
  • 29% and 27% of borrowers that paid off loans early were with credit grade A and B respectively.
  • 20% of such loans were issued to borrowers with credit grade A for amount less than $10,000.

Key Takeaway

I defer to Mr. RT for detailed analysis in the future. But what I concluded for my lending criteria is to avoid good credit borrowers for low loan amount because they may pay off early and cause the expected return of portfolio to be lower.

Now I will have to be careful in selecting both extremely good and bad credit borrowers.


9 comments:

  1. The cost of an early payoff is so low that you better do some work to figure out what you would be giving up by avoiding loans with the characteristics that tend to predict prepayment. They tend to be the same characteristics that predict payment in general. I view the early payoffs as a cost of doing business.

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    1. Yes, I’d like Mr. RT to narrow down the characteristics of people who may pay off early.
      I agree it’s a good way of thinking as business cost. My bank requires daily minimum balance of $1,500 in the checking account without any interest. They would charge hefty $12 when the balance is short. I can live with paying several cents or even a few dollars occasionally while I’m gaining 10+% interest through Lending Club. Thank you for reminding me.

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  2. I have been with LC since November 2009. Since January this year I had 33 loans paid off, in which 10 were paid off in the first month, and 5 were within 3 months. All were $25 & $50 loans. The rest were between 10 to 30 months with the loan amounts up to $500 per loan. Didn't think much of it until I found this article - think LC should do something about it.

    Also, the default seems to have increased significantly in the last 6 months, many are with the loan amount less than $5k, A to C grades loans.

    Lastly, thank you for many wonderful articles. I have learned a lot about lending from RT.

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    1. By "RT", I hope you mean Mrs. RT? :) Thank you for reading and interacting with me.

      Thank you for sharing your experience. It's rather shocking for me to find out 15 loans were paid off within 3 months! Do you see any patterns?

      In one of his posts, Mr. RT recommended to avoid small loan amount and I'd avoid less than $5K.

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    2. Yes :)

      Re the early paid off loans, there isn't seemed to have any patterns (except that they were all first time borrowers) but my (probably offkey) guess. My guess is, these borrowers used the first loan to build up credit score or earn trust from LC and its lenders – I'm saying this as a mixed positive & negative ways.

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    3. How are you able to find out those LC borrowers are the first time borrowers? I'd like to know.

      Also, Peter Renton recently explained about service fee in detail in his post You should check it out.

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  3. I use "Inquiries in the last 6 months" to define first time borrowers, but now think of it, it's probably inaccurate. Perhaps it's easier to find out from "Borrower Member_ID" but there is no filter to do so. Would be nice if LC can show repeated borrower option.

    Thanks for suggesting Peter Renton's post.

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    1. As you mentioned, "Inquiries in the last 6 months" is not the information to indicate repeaters. That number means borrowers applied to other loans in the last 6 months. I use the data to exclude borrowers applying to loans recently. Now I'm guessing based on your experience, if borrowers are shopping around loans and they find better loan, they pay off Lending club loan early. There's no way we, investors, can identify repeaters in Lending Club.
      We've been investing on Prosper, other P2P lending platform. My future post will cover the observation of differences of two platforms. Stay tuned :)

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  4. I got two early paid off today, one the first month and the other third. It's certainly very discouraging.

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