Screening and scrubbing through available loans on Lending Club is a lot easier once you know what you’re doing. Using the net return and default rates screener at Nickel Streamroller, one can quickly “backtest” various selection strategies to find the loans with the best ROI.
I’ve tested a few different ways to weed out Lending Club borrowers with great success. Here’s a few ways to increase returns while decreasing loan defaults:
- Credit card and debt consolidation loans – The simple point here is that you want to loan to people who understand concepts like interest, fees, and other finance charges. By limiting the selection to people who will use a loan for credit card debt or other debt consolidation, you limit the pool to people who are (at least from what we can guess) making steps to improve their finances. I especially like using this filter, since credit cards and a typical car loan refinance has an amortization similar to the 36-month horizon of a Lending Club loan. The net effect on the borrower’s cash flow is tiny. Arguably, “renewable energy” loans should give some cash flow savings to the borrower also, but the long-term rewards of renewable energy do not align very well with a 36-month amortizing loan. Additionally, Nickel Steamroller only has a small sample of renewable energy loans.
- Loan Amount – Interestingly, defaults are higher on the lower-end of the loan amount curve. The $500-2000 loans seem to have very high default rates. Thinking this through, I suppose the reason should be obvious – if you need a $2500 credit card or debt consolidation loan, then you’re already in a bad situation. Moving the “total amount funded” up to $5,000 moves the ROI to over 7% for B-E rated borrowers.
- Removing sketchy borrowers – I then change the inquiries per borrower down to 0-3 in the past six months. Those with more inquiries have apparently been declined by other lenders for a consolidation loan, or maybe another credit card, in the past six months. If someone is actively seeking several new loans while pledging to consolidate and pay off existing debt, something is wrong. Reducing inquiries seems to reduce default rates all the way down the credit quality curve.
- Total revolving debt – As we moved the loan amount up to $5,000 earlier, I moved up the “revolving credit balance” qualifier to $4,000. Returns increase, likely because borrowers who can handle a high interest credit card balance can handle a low-interest amortizing loan for 36 months. Again, pushing out people with small balances means that your loans are going to people who will use the bulk of their loans to repay high-interest debt. You don’t want to fund someone who thinks he or she can magically repay 10 years worth of low-interest student loan debt in 3 years.
- Monthly income – Unfortunately, Nickel Steamroller has very little data on income. You can move the borrower’s income in four thousand dollar jumps from $0 to $4000 per month. This reduces defaults and increases returns, especially for borrowers who might be considered less creditworthy in the D and E credit ranges.
Forward Testing the Model
All things considered, these five criteria give a historical return of anywhere between 5-10%. Excluding A grade loans, the selection and screening criteria show that investors can earn at least 8% on their money.
You can move the year of the loans up and down to see how your criteria would perform in the years following the worst of the global financial crisis. (The returns above are for loans issued in the 2010-2011 years with the rules above and 36-month amortization.) Admittedly, loans issued in 2010-2012 could still go into default, so any investor has to be careful not to take the returns dollar for dollar. Even still, I do think it is safe to say that loans issued in 2012 will likely outperform loans that were issued in 2008-2009 – this is consistent with data from credit card and car loans issued in the post-recession (ha!) economy.
If you enjoyed this post, learn about more types of Alternative Investments here. It’s a great idea to diversify out of standard stocks and bonds to both improve your diversification and also to increase returns.
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