Lending Club Loan Length - Credit Grades and Default

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You may recall a few weeks ago, Michael at Nickel Steamroller wrote a very interesting blog post Balancing Your Portfolio by Loan Term - 36/60 Month using the spread he painstakingly recorded for currently available loans on Lending Club. Let's compare his findings with analysis of Loan Term in my previous post Lending Club Loan Length: Best 60 month spread with B4 Grade Loan. Let's see if I can answer some of his questions.

"The higher interest rate [for 60 month loan] is to reflect the additional time you have to put your money at risk."

This statement is true but Lending Club goes about it in a round-about fashion. Lending Club reduces the Credit Grade of 60 month loan instead of increasing the interest rate while maintaining the Credit Grade. I assume most investors, as I do, compare the loans of same Credit Grade when selecting loans for investment. So, they don't necessarily pick higher returns with 60 month loans but potentially lower default risk for such loans. If you want higher interest rate/return with 60 month loan, look for such loans with Credit Grade that are within 5 or 6 credit sub-grade from your target Credit Grade criteria for 36 month loan selection.

"If you see the spike for D1 there was actually no spread on the currently listings. There was only one D1 [60 month loan] on the system (Member Loan ID 1333671). Not sure why this was."

As mentioned in my previous post, Lending Club's underwriting process skips D1 credit grade for 60 month loans. The only way of having a D1 grade credit loan is to change the loan amount. This is also the reason why there was no spread listed on D1 loan as Lending Club can't give D1 grade to a loan just by changing the loan length. The chart below shows the loan volume in 2010 and 2011 for all Credit Grades and Loan Lengths. As the chart shows, there is a discontinuity in loan volume at Credit Grade D1 for 60 month loans. Also, there are very few 60 month loans with Credit Grade A.

Credit Grade and Default Rate

Before I review the defaults as a function of credit grade, readers need to keep in mind that the historical loan data file was captured at the end of April 2012. So only loans listed in the first four months of 2010 have aged two years.

The chart below shows the charged-off and default for 36 month and 60 month loans. The 60 month loans listed during the second quarter of 2010 are the oldest loans. As the chart shows for Q2 of 2010, except for Grade D loans, the default rate is higher for 60 month loans. With further aging, I expect that default rate for 60 month Grade E and F loans may be lower considering the high number of 36 month loans with late payments in these grades. The similar patterns are observed for 2010 and 2011.

I made following observations from the chart for loans listed in 2010. Please share any additional insights you may have through comments.

• For A grade loans, the default rate for 60 month loans is higher than that for 36 month loans. For B and C grade loans, the default rate follows similar pattern. In aggregate, the default rate for A, B, and C grade loans is 6.16% for 60 month term versus 4.34% for 36 month term.
• The pattern reverses for D, E, F, and G grade loans. The default rate for 60 month loan is lower than that for 36 month loans. In aggregate, the default rate for D, E, F, and G grade loans is 9.064% for 60 month term versus 10.669% for 36 month term.
• This reversal of pattern is most probably due to a large difference in loan volume with 36 month and 60 month terms. For example, 19.98% of grade A, B and C loans were of 60 month term compared to 49.32% of grade D, E, F, and G loans of 60 month term. The chart below shows number of 36 and 60 month loans for last three quarters of 2010.

It appears that Lending Club's underwriting process does well in matching the default risk between 36 month loans and 60 month loans using the credit grade of the loans. It remains to be seen how much more the default rate for 60 month loans will rise because such loans listed in Q2 of 2010 have completed only 2/5th (40%) of maturity term compared to 2/3rd (66%) of maturity term for 36 month loans.

Key Takeaways

• Lending Club's underwriting practice to downgrade the Credit Grade of 60 month loan to adjust for extra risk is at best confusing for lenders. A practice of maintaining Credit Grade but increasing the interest rate on 60 month loan would be much more clear as most lenders on its platform understand higher risk deserves higher return.
• Lending Club may need to provide resources that explain and educate lenders on credit risk evaluation. Otherwise, similar to NSR, lenders may turn away from longer maturity loans.
• Comparing default rate of 60 month loan with 36 month loan for the same Credit Grade is like comparing oranges to apples. Lenders may need to shift credit grade 5 or 6 steps for 60 month loan to get a fair comparison of default rate with 36 month loan.

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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.

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Lending Club Loan Length and Default Rate

If you are new to peer to peer lending, check out the introductory article An Introduction to Peer-to-Peer Lending by Peter Renton.

Loan Length

Lending Club issues loans with two different maturity lengths - 36 months (3 years) and 60 months (5 years). The loans with 60 month term were first introduced to Lending Club platform in May 2010, a little over two years ago. In 2011, the loans with 60 months term became very popular as more than 50% of the loans listed on Lending Club had 60 month loan repayment term. The chart below shows the number of loans listed every quarter with 36 and 60 month terms. It appears fewer loans with 60 month term are being listed in 2012.

Default Rate

The chart below shows the percentages of loan with 36 and 60 month terms in either charged-off and default status or in grace period, late and performing payment plan status. As the chart shows, the charged-off and default rate for 60 month term loan is almost twice the default rate for 36 month term loan for the same quarter of loan listing date.

Originally, I assumed that fewer borrowers may default with longer maturity of loan as borrowers will have smaller monthly payment. The chart shows this not to be the case. In fact, the borrowers are twice as likely to default with loans of longer maturity.

This observation is inline with Michael's real-life experience of much higher default rate with 60 month notes as described in his blog post Balancing Your Portfolio by Loan Term - 36/60 Month. A quick back-of-the envelope calculation for his portfolio default and late payment rate is shown below. It will also help some readers who requested examples of using default rates.

Assuming Michael has portfolio of 100 notes with 76% of portfolio in 60 month notes and all notes were listed in second quarter of 2010.

Number of 60 month notes in portfolio = 76% * 100 = 76
Number of 36 month notes in portfolio = 100 - 76 = 24

From the above chart, the default rates for 36 month and 60 month notes are 6.24% and 11.45% respectively. Similarly, the late payment rates are 3.36% and 3.61% respectively.

Default and late payment rate for 36 mo. notes = 6.24% + 3.36% = 9.60%
Default and late payment rate for 60 mo. notes = 11.45% + 3.61% = 15.06%
Number of 36 mo. notes in default or late = 9.60% * 24 = 2.304
Number of 60 mo. notes in default or late = 15.06% * 76 = 11.4456
Percentage of notes in default or late that are 60 mo. notes = 11.4456 / (2.304 + 11.4456) =  83.2%

Michael reported 95% of his notes in default or late are 60 month notes. Considering our assumptions of all notes issued in same quarter, we came up pretty close with 83.2% of notes in default or late should be 60 month notes.

Days between Loan Listing and Issued Date

The chart below shows the number of loans issued as function of days between loan listing and issued date between 2010 and 2012 for both 36 month term and 60 month term. The dotted line represents decile and each decile is 10% of loans. For example, one decile line indicates 10% of 36 month term loans were issued within three days of listing while 10% of 60 month term loans were issued within four days of listing. Similarly, two decile line indicates 20% of 36 month term loans were issued within six day of listing while 20% of 60 month term loans were issued within seven days. The chart shows that loan length has negligible influence on days required to fund and issue the loans. Update July 6, 2012: Please ignore the decile lines on the chart and related findings. There is a mistake in my interpretation of how Tableau calculated the deciles.

The chart below shows the percentage of loans with status charged-off and default or in grace period, late, and performing payment plan for both 36 month term loans and 60 month term loans for 2010 and 2011. The default rate for 36 month term loan is much higher when such loans were issued about 3 weeks after being listed. The default rate for 36 month term loans rises when it takes longer to issue loans after being listed. The default rate for 60 month term loan shows very different pattern. The 60 month term loans issued within four days of listing have much higher default rate.

Key Takeaways

• Reducing the monthly repayment amount by lengthening the loan maturity doesn't reduce the risk of borrower default. In fact, the borrowers are more likely to default with longer maturity debt.
• The coat-tailing strategy, described in my previous post Days Between Listing and Issuance of Lending Club Loans - Rush at Listing Expiration, may be a good strategy to invest in 36 month notes.
• Personally, I have stopped investing in 60 month notes until I further understand the mechanics of setting interest rates for such loans and able to observe the default rate of 60 month loans to maturity.

Interested in Data Visualization, check out The Visual Display of Quantitative Information and New Perspectives on Microsoft Excel 2010: Comprehensive.