Loan Duration and Principal Remaining at Charge-Off

Prospective borrowers on sites such as LendingClub and Prosper have the choice of applying for loans of various duration, most commonly 36 or 60 months.  Similarly, investors have the ability to choose which loans to fund.  Often, investors prioritizing liquidity will skew more towards shorter-duration loans, while those who are more cash-insensitive may opt to include some 60-month investments.  In today’s analysis, we examine the financial implications of investing in various loan terms, their likelihood of charge-off, and the magnitude of credit loss incurred at various points over a loan’s payback period.

Distribution of Loan Duration

In the graph below, we can see the breakdown of loan durations on Prosper over the past several years.  Beginning in 2012, 60-month loans have gained in popularity and now comprise a significant portion of overall originations.

Incidence of Charge-Off by Loan Term

In the graphs below, we see the “cumulative event charge-off curve” for 36 and 60 month loans on Prosper.  These numbers indicate the cumulative percentage of loans (not dollars) that have experienced a charge-off at or before a certain point in time post-origination.

From these graphs, a few things are apparent.  First, overall charge-off rates have decreased sharply each year, with the 2013 vintage proving to be very low risk thus far in its tenure.  In addition, 36-month loans and 60-month loans seem to have similar event-charge-off curves, at least over the past 2 years.  This would suggest that accounts of both durations go bad at similar rates.

Not only do these accounts seem to go bad at similar rates; they also seem to go bad at similar times.  Among 2012 loans, those that eventually charged-off did so, on average, 12 months after origination.  This is true for both 36 as well as 60 month loans.

Amortization Schedule & Balance at Charge-Off

At first glance, one might be tempted to wonder why all this matters. If both lengths of loan perform similarly, isn’t that a good thing?  Remember, however, that loans of different duration amortize at different rates, and the point in a loan’s tenure at which a charge-off occurs will have a significant impact on the actual dollar amount of credit loss.

In the graph below, we show the principal paydown schedule for a 36 and 60 month loan, each with a $10,000 initial balance and annualized interest rate of 12%.

By definition, loans of longer duration pay down over a longer period of time.  Of course, it is important to understand the downstream implication of this truism: all other things being equal, if two loans stop paying at equivalent points in their tenure, the longer duration loan will have a greater balance outstanding at charge-off.  For example, let’s crunch the numbers to see what would happen if the 2 loans in the above graph were to stop paying at 12 months post-origination:

For 2 loans with the same initial amount, same annualized interest rate, and same time-to-default, the loss incurred on the 60-month loan is materially higher.

The Bottom Line

As this analysis has shown, the duration-mix of an investor’s direct lending portfolio is more than a consideration of liquidity alone.  The payback schedule of a longer-term loan means that investors may benefit from analyzing and calculating potential risk and returns separately for loans of differing duration.