Monday, June 25, 2012

Lending Club Loan Length: Best 60 month spread with B4 Grade Loan

Loan Length impact on Interest Rate

The chart below shows a Scatter Plot of Interest Rate and Credit Grade from 2010 to 2012. The color of circle represents the loan length and size of circle represents number of loans listed with specified interest rate, credit grade, and loan length. Initially, when I saw this chart I was surprised as I expected interest rate for 60 month loan to be higher than that for 36 month loan in same credit grade. As the chart shows, this is not the case. Interest rates for both 36 month and 60 month loans are same when loans are in the same credit grade.

After reviewing the information on how Lending Club sets the interest rate and prospectus [PDF], it became clear that Lending Club incorporates the difference in loan length by dropping the credit sub-grade five or six steps for 60 month loan.
"Seventh, we modify the sub-grade based on the term of the loan as follows:
Loan Term Sub-Grade Modifier
Three years 0
Five years
A1 - B5 (5)
C1 - G5 (6)

By adding the modifiers to the initial sub-grade, we arrive at the final sub-grade of the requested loan based on the initial credit criteria."
For example, let's assume the credit grade for a 36 month loan is A1 with 6.03% interest rate. If only the loan term is changed to 60 month, the credit grade for this 60 month loan will be B1 with 9.76%. In fact, by changing only the length of the loan, the interest rate on new 60 month loan increased 3.73%. Similarly, a C1 credit grade 36 month loan with 13.99% interest rate will change to D2 credit grade 60 month loan with 17.99% interest rate, an increase in interest rate of 4.00%.

Loan Length impact on Credit Grade

The chart below shows the new Credit Grade and new Interest Rate if length of a loan was changed from 36 months (Blue dots) to 60 months (Orange dots), without changing any other parameters of the loan. The sub-grade of 36 month loans is listed at the bottom of the chart. The sub-grade of equivalent 60 month loans is listed at the top of the chart. The gray bars show the extra interest rate (spread) for 60 month loan term. The scale for extra interest rate (gray bars) for 60 month loan is on the right side of the chart. The scale for interest rate on 36 month loan and 60 month loan is on the left side of the chart.

You may notice that there is no sub-grade D1 for 60 month loan. The reason for this anomaly is that if loan sub-grade is in A1 - B5 range, Lending Club drops the sub-grade 5 steps, i.e. the new loan sub grade is in B1 - C5 range. But if loan sub-grade is in C1 - G5 range, Lending Club drops the sub-grade 6 steps, i.e. the new loan sub grade is in D2 - G5 range. In fact, skipping sub-grade D1 in the underwriting process.

As you are more attentive now, you may notice and ask why are the loan sub-grade F5 - G5 range for 36 month loans and loan sub-grade A1 - A5 range for 60 month loans missing in the chart? If the only parameter changed for loan is the loan length, Lending Club can't have 60 month loans in the missing A1 - A5 ranges because the credit sub-grade of equivalent 36 month loans will need to be left of A1. Lending Club only defines credit sub-grades from A1 to G5. Similarly, no sub-grade above G5 is defined by Lending Club so you can't have equivalent 36 month loan with sub-grade right of F5 to be able to drop the sub-grade 6 steps for equivalent 60 month loan.

Now, you are paying much more attention, you may notice in the first chart at the top that there are a few 60 month loans in the credit sub-grade A1 - A5 and ask how is this possible? Well, let me tell you a story of a guy going to a car dealership to buy car through financing.

A guy goes to a car dealership to buy a car that cost $20,000. He wants to keep the monthly loan payment as low as possible. The nice car salesman says no problem, I will extend you our longest financing term of 60 month and your monthly payment will be $350. But, the guy want to keep monthly payment at $300. The car salesman really wants his commission from this car sale but he also can't increase the term of the loan any further. So, he convinces the guy to borrow little lower amount to keep the monthly payment at $300. Same sort of thing is most likely happening at Lending Club.

Lending Club only has two levers, Loan Length and Loan Amount, that it can pull to change the Credit Grade, resulting in change in Interest Rate, and resulting in change in Monthly Payment. All other parameters used for calculating Credit Grade of a loan are influenced by borrower's credit report. When borrower balks at monthly payment or interest rate, Lending Club most likely suggests to lower the requested loan amount to reduce the sub-grade resulting in lower interest rate and monthly payment.

Best Bang for the Buck

According to above chart, you will receive additional 5.21% interest rate by investing in B4 60 month loan over an equivalent A4 36 month loan. It is the largest spread (gray bar) among all 60 month loan credit grades. The abnormally high spread (greater than average + one standard deviation) is received for 60 month loans with sub-grades B3, B4, B5, and C1. The abnormally low spread (less than average - one standard deviation) is received for 60 month loans with sub-grades F5, G2, G3, G4, and G5.

Key Takeaways

  • The interest rates for 36 month and 60 month loans of same Credit Grade are same. Lending Club compensates for higher default risk with the longer length of 60 month loans by changing the Credit Grade of 60 month loan.
  • A lot fewer 60 month loans will be issued with Credit Sub-Grade D1, A1, A2, A3, A4 and A5 due to this quirk in Lending Club underwriting process for 60 month loans.
  • Lending Club only has two levers - Loan Length and Loan Amount to influence the Credit Grade, the Interest Rate and Monthly Payment for a loan.
  • The best bang for the buck, a spread of 5.21%,  is offered by Credit Grade B4 60 month loans over equivalent A4 36 month loan.
Recently, Nickel wrote an interesting comparison of "real-life" returns of a low risk portfolio and high risk portfolio in article Lending Club High vs. Low Risk Loan Experiment Complete. Check it out.

Interested in starting a business, consider reading Nail It then Scale It: The Entrepreneur's Guide to Creating and Managing Breakthrough Innovation and The Startup Owner's Manual: The Step-By-Step Guide for Building a Great Company.

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