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Another reason future years decline

Started by Peter, July 20, 2017, 11:00:00 PM

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A recent post by SeanMCA on another thread made me curious about the impact of the service charges on fully paid loans. Unfortunately, this led me down a path looking at payments made on a specific loan. I duplicated the calculations Lending Club made with each payment and realized how misleading the interest rate is. They compute the interest on the declining balance (as they should) but as the payments add up, the interest you earn declines.

I did an example starting with $100 invested at 10%. The borrower would have to pay back about $3.25 a month to pay this off in 36 months. Following is a chart of the first few months of payments.

Year   Month   Balance   Payment   Interest   Pd Princ   New Bal
10.00%   0   $100.0000            $100.0000
1   1   $100.0000   $3.2500   $0.83   $2.4167   $97.5833
1   2   $97.5833   $3.2500   $0.81   $2.4368   $95.1465
1   3   $95.1465   $3.2500   $0.79   $2.4571   $92.6894
1   4   $92.6894   $3.2500   $0.77   $2.4776   $90.2118

If you take this through the 36 months and total by year, you get the following sums.
   Amt Pd   Interest   Balance   Ret/$
Year 1   $39.0000   $8.6332   $69.6332   8.63%
Year 2   $39.0000   $5.4534   $36.0866   7.83%
Year 3   $39.0000   $1.9406   -$0.9727   5.38%
Life   $117.0000   $16.0273      5.34%

You earned $16.03 in interest on $100 over 3 years. That is an annual return of 5,34%. If you add in the service fee (totals $1.17), your return is further reduced to 4.95%. And, these assumptions to not consider the impact of charge offs and fully paid loans.

The only way you can continue to get near 10% is to constantly re-invest the money you receive. When you want off this merry-go-round, you will pay a penalty.

Where am I wrong?


The keyword is amortized loans. These loans are constant repayment declining balance loans. Interest / Remaining Principal ratio stays the same during the life of loan sans default.

You can take the repayments out of account and invest anywhere else you like. There is no penalty for getting off the merry go-round. Continuous reinvesting gives appearance of higher return because repayments on newish loans mostly consist of interests and little of principal repaid. Once you reach a level reinvesting rate, you portfolio returns will level off too. San defaults, return fluctuate mostly when money is added and deployed to or cashed and withdrawn from account.

You are trying to find fault where there is none."> from: OleBill on July 21, 2017, 05:17:59 PM


I'll give an example to highlight the point:

Imagine there was an investment that returned 1% each day. But every single day, in the evening, they gave you all your money back. Each night, you had to decide whether or not you wanted to invest the following day.

You start off with $100. That night, they give you $101. You decide to re-invest and give them $101 for the next day. At the end of the next day, they hand you $102.01. This continues for 1 week, after which you have $107.21. They return this money to you. This has been great, you've been having an average rate of return of 1% per day. This night however, you decide you don't want to reinvest. You do this 1 week. So after 14 days, you still have $107.21. This means your average return over 14 days, more or less, dropped from 1% per day to 0.5% per day, solely because you stopped investing. This makes sense, if you don't invest your money, you won't make any returns, and your average rate of return decreases as time passes.

In the case of LC, it's similar to the above example, the only difference being that each night they give you back ~0.07% as opposed to 100%. If you don't re-invest what they give back to your, your average rate of return will decrease. However, the rate of return for the money that you still have invested, will remain the same.


I haven't used the historical data to estimate age as it will be too time consuming and computing intensive if at all possible.

But I have modeled it with lot of simplifying assumptions. If you made one-time lump sum cash infusion at the start and are lending at 12% rate on first day of each month, reinvesting all monthly repayments, deposit/withdraw no cash from account and encounter no defaults, the weighted portfolio age should be about 17.4 months for 36 month loan portfolio 107 months after opening the account and about 27.5 months for 60 month loan portfolio 178 months after opening the account. In short, we are looking at a decade or more before portfolio reaches steady rate of reinvesting after large initial investment. Another way to look at it that it will take almost 3x of loan term before you reach steady reinvestment rate.

I haven't modeled it but I expect a DRIP like program to reach reinvesting steady state much quicker in my modeled scenario. Defaults are very difficult to model as timing and magnitude will change the reinvestment dollars available every month.

There may be an approximation method from the Bonds and MBS domain but I haven't looked into it."> from: sensij on July 21, 2017, 08:00:48 PM


Thanks for the great responses, APC, Fred93. I have definitely been looking at it wrong. 


You're not wrong. The way they calculate and post returns is a total joke. If you also factor in the taxes and or fees you will have to pay when you go to file at the end of the year, and or the fees at SDIRA to close your account. You will absolutely be in the negative. 


The weighted average portfolio age is only calculated for active notes, i.e. the loans that have not defaulted or fully paid. So the calculations are only weighing active notes and premature defaults and prepayments may have little impact on the portfolio age, most probably timing of defaults and prepayment have more impact.

After plotting the portfolio age with months, I realized the portfolio age reaches a plateaus pretty quickly once initial loans have matured. So I need to correct my earlier interpretation that it may take over a decade. It looks like we might reach ~17 months portfolio age plateau for 36 month loans by ~72 months and reach ~27 month portfolio age plateau for 60 month loans by ~120 months in the model constructed under assumptions as mentioned before. Basically 2x term may be a good rule of thumb. See the attached portfolio age charts for both 36 and 60 months portfolio."> from: sensij on July 24, 2017, 03:02:03 PM

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