When (do) Good Loans Go Bad

The borrower already has your money, and now you hope that he pays you back.  This simple fact is the fundamental challenge of being a lender and something of which I often remind my colleagues.  The lender earns interest revenue on outstanding balances and takes losses on the balances that end up unpaid.  Ideally, the first number is larger than the latter, and you make a profit.  On the major P2P lending exchanges, this has largely been the case, and very few diversified investors have experienced a net loss.  In fact, LendingClub advertises on its site that among investors with at least 100 notes and no single note comprising more than 2.5% of assets, over 99% have experienced a positive return.

Nevertheless, some loans will become delinquent, and a portion of those will charge off.  It is useful for a well-informed loan investor to understand the dynamics behind these events.

When do late payments happen?

When borrowers decide to take out a loan, they conceivably do so with the expectation of being able to make the payments, and as such, “first payment defaults” are rare.  In the subsequent months and years, however, late payments may happen.

As an example, for 36-month LendingClub loans originated in 2010, 14.72% went 30 days past due at some point during the loan’s lifetime.  Many of these caught up and went on to perform satisfactorily, while some rolled further into delinquency and perhaps even charged off.

Let’s take a look at when delinquencies actually took place.  The graph below shows when late payments first occurred for the above-referenced population of loans:

5% of loans that went 30 days late at some point first did so at month 6.

50% of loans that eventually went 30 days past due did so by the first year.  This front-loading makes sense; the longer a borrower has been able to make his payments, the more likely he is to continue being able to do so.

When do charge-offs happen?

For charge-offs, what matters is the actual balance charged-off, rather than the number of accounts.  For 36-month LendingClub loans issued in 2010, 5.70% of originated dollars eventually were charged off.  When did these charge-offs peak?

As we can see, chargeoffs tend to peak around the end of the first year post-origination.

Over 50% of dollars that would eventually charge off did so by the 15th month.  By month 26, 90% of charge-offs had already taken place.

The Bottom Line

While delinquencies and even charge-offs are facts of life, a well-diversified investor will usually end up ahead.  By understanding the seasoning of the vintages that make up your portfolio, you will have greater insight into how your rate of return may fluctuate over time.