Lending Club Risk Avoidance Investment Strategy

Tags: Lending Club, Strategy

Risk Avoidance Strategy

The premise behind this Lending Club investment strategy is to get high returns by limiting exposure to borrowers who have attributes linked to historically high default rates. I have analyzed an export of all loan data provided by Lending Club on their statistics page to determine default rates for each of the values in a given attribute. Through the process of writing this post I have found a better understanding of the risks associated with any attribute, breaking some of my prior held assumptions. I hope this filtering strategy helps you get better returns as it has for me.

The following statuses are used in determining what constitutes a default loan.

  • Charged Off
  • Default
  • In Grace Period
  • Late (16-30 days)
  • Late (31-120 days)
  • Performing Payment Plan

Many of these statuses are not technically defaulted, but historically late loans end up defaulting 25%-75% of the time.

Criteria Explanation

Before getting to the criteria selections below, let me quickly explain what the data in and below the images mean.

Historical
Statistics on all 51,461 loans from the raw data export.
Current
Statistics from the 881 loans in funding when I started writing this post.
Criteria
The categories that should or should not be used when applying the filters. The ones to exclude are highlighted in red. I have chosen 7.5% as the cutoff mark for category selection. Using a lower default rate excludes too many loans, but could be done if one favors a more conservative approach.
Result
This shows how many loans can be excluded by applying the criteria to the historical and current set of data.

13 Key Criteria Summary

If you're only interested in getting the criteria to use to reduce your risk then here's the quick list.

  1. Years Since Last Delinquency: No Delinquencies
  2. Employment Length: Exclude those with less than two years
  3. Loan Purpose: Include Car Financing, Credit Card Refinancing, Major Purchase, Wedding Expenses, Debt Consolidation, Home Improvement
  4. Revolving Balance Utilization: Exclude those with 0% and 80% or higher
  5. FICO Range: Exclude below 679
  6. Credit Line Ratio: Exclude those with less than 20% and 70% or more
  7. Open Credit Lines: Exclude those with less than 5 or more then 19
  8. Total Credit Lines: Exclude those with less than 10 or 60 or more
  9. Inquires Last 6 Months: Exclude those with 3 more inquires
  10. Delinquencies Last 2 Years: No Delinquencies
  11. Debt to Income Ratio: Exclude those with 0-3% DTI
  12. Years Since Last Record: Exclude all that have had any historical records
  13. Home Ownership: Exclude any and none

Criteria Strategy In-Depth

The criteria has been ordered by most impact to reducing the pool of loans that need to be considered before investing.

1) Years Since Last Delinquency

Default Rates: Years Since Last Delinquency

...a situation where a borrower is late or overdue on a payment, such as income taxes, a mortgage, automobile loan or credit card account.

Investopedia

Criteria No Delinquencies

Result Historically removes 35.6% or 18,332 loans and in current sample removes 31.0% or 273 loans

Highest risk comes from those borrowers who had a recent delinquency. There is a small drop, to back under my 7.5% max, around the three to four year mark, but it goes back up in the following years. Reason not to include these is because in one to two years they’ll be back in the higher risk group. It is surprising that Lending Club allows in so many borrowers who have had credit issues.

2) Employment Length

Lending Club Default Rates: Employment Length

Criteria Exclude those with less than two years experience

Result Historically removes 22.4% or 11,507 loans and in current sample removes 26.0% or 229 loans

The default risk rate is fairly low for this filter, but those without an established career or no job at all, may have difficulty in paying if something happens to their income source.

3) Loan Purpose

Lending Club Default Rates: Loan Purpose

Criteria Include Car Financing, Credit Card Refinancing, Major Purchase, Wedding Expenses, Debt Consolidation, Home Improvement

Result Historically removes 20.4% or 10,488 loans and in current sample removes 18.1% or 159 loans

Several options here don’t have enough historical data to make the default percentage very accurate. For now I'm staying away from loans dealing with renewable energy, business, and education since they have a high risk of default, even though I'm interested in those areas. Surprisingly car financing has a decent number of loans and has the lowest risk rate, I would think that the interest rates offered by dealers are lower then what Lending Club can provide. Perhaps these are mostly used car loans where it may be harder to get a bank loan at a low rate.

4) Revolving Balance Utilization

Lending Club Default Rates: Revolving Balance Utilization

...the relationship between the balances on your credit cards and the credit limits on all of your open credit card accounts.

Mint

Criteria Exclude those with 0% and 80% or higher

Result Historically removes 18.4% or 9,462 loans and in current sample removes 21.0% or 185 loans

This statistic shows how much of their available credit a borrower uses. This attribute, along with several others that go into use of credit, show that those with no experience with credit and those that max out their available credit have a higher risk for defaulting on their loans.

5) FICO Range

Lending Club Default Rates: FICO Range

Using mathematical models, the FICO score takes into account various factors in each of these five areas to determine credit risk: payment history, current level of indebtedness, types of credit used and length of credit history, and new credit.

Investopedia

Criteria Exclude below 679

Result Historically removes 17.1% or 8,777 loans and in current sample removes 15.2% or 134 loans

Those with low FICO scores most likely have difficulty in getting loans from traditional financial institutions and give Lending Club a shot. Note that the under 660 group with the 30.5% risk of default don’t have a large enough sample size give that default rate a lot of accuracy, but it still show’s that this group is highly risky. In another post I’ll go into how I review funded loans in my portfolio for signs of default with the intent to sell them off. This is one of the key pieces of information I look at to make that determination.

6) Credit Line Ratio

Lending Club Default Rates: Credit Line Ratio

This statistic shows the ratio between open lines of credit and total lines of credit.

Lend Analyst

Criteria Exclude those with less than 20% and 70% or more

Result Historically removes 16.5% or 8,465 loans and in current sample removes 15.6% or 137 loans

This goes hand in hand with the revolving balance utilization filter mentioned before by reaffirming that those who don’t use credit a lot or those who exceed their usage show higher risk then borrowers who fall in the middle. The basic idea to take away is to stay away from borrowers who hit either extreme.

7) Open Credit Lines

Lending Club Default Rates:  Open Credit Lines

The total number of open accounts appearing on the borrower's credit report.

Prosper

Criteria Exclude those with less than 5 or more then 19 credit lines

Result Historically removes 14.0% or 6,981 loans and in current sample removes 7.5% or 66 loans

Similar relationship of credit usage to risk as the revolving balance utilization and credit line ratio.

8) Total Credit Lines

Lending Club Default Rates: Total Credit Lines

The total number of credit lines appearing on the borrower's credit report.

Prosper

Criteria Exclude those with less than 10 or 60 or more total lines of credit

Result Historically removes 12.5% or 6,425 loans and in current sample removes 8.1% or 71 loans

The relationship between credit usage at the extremes to default risk is enforced again by this statistic.

9) Inquiries last 6 months

Lending Club Default Rates: Inquiries last 6 months

A transaction whereby a bank or other credit-issuing institution views an individual’s credit report in connection with a loan or credit card application. The purpose of a credit inquiry is to evaluate an individual’s likelihood to repay money that is lent to them (known as creditworthiness).

Investopedia

Criteria Exclude those with 3 more inquires

Result Historically removes 12.2% or 6,280 loans and in current sample removes 7.7% or 68 loans

Initially I had this at the top of my list of filters to implement since the default risk rises dramatically with each extra inquiry past two. As you can see though, Lending Club doesn’t let in many borrowers who have been rejected by other financial institutions a high number of times, so while this is an important filter to include, it won’t reduce the loan pool by much.

10) Delinquencies Last 2 Years

Lending Club Default Rates: Delinquencies Last 2 Years

...a situation where a borrower is late or overdue on a payment, such as income taxes, a mortgage, automobile loan or credit card account.

Investopedia

Criteria No delinquencies

Result Historically removes 10.7% or 5,486 loans and in current sample removes 10.0% or 88 loans

Anything that deals with having issues with paying debt in the past shows a higher rate of default. Borrowers who show a history of bad money management skills show a tendency to repeat those same mistakes in the future.

11) Debt to Income Ratio

Lending Club Default Rates: Debt to Income Ratio

A personal finance measure that compares an individual's debt payments to the income he or she generates. This measure is important in the lending industry as it gives lenders an idea of how likely it is that the borrower will repay the loan.

Investopedia

Criteria Exclude those with 0-3% DTI

Result Historically removes 9.2% or 4,738 loans and in current sample removes 6.2% or 55 loans

Before doing this analysis, I stayed away from DTI’s higher than 20%, but the risk was really at the lower end of the spectrum. Given the small sample size, the 28-30% DTI low risk rate may not be accurate, more data may cause this to rise. After all, Lending Club hasn’t accepted borrowers with ratio’s higher than that, so there must be some indicator showing a higher default rate past the 30% mark.

12) Years Since Last Record

Lending Club Default Rates: Years Since Last Record

Public records are legal documents created and maintained by Federal and local governments, which are usually accessible to the public. Some public records, such as divorces, are not considered by your FICO score, but adverse public records, which include bankruptcies, judgments and tax liens, are considered by the FICO score. Your score can be affected by the mere presence of an adverse public record, whether paid or not.

myFICO

Criteria Exclude any borrowers that have had any historical records

Result Historically removes 7.7% or 3,941 loans and in current sample removes 3.1% or 27 loans

A record is a claim made by a credit institution on the borrower's credit history. Any number of such records shows a very high rate of default. This is similar to the inquires in past six months statistic, in that the sample size of borrowers who fall into the excluded list is small, but their default risk is very high.

13) Home Ownership

Lending Club Default Rates: Home Ownership

Criteria Exclude any and none

Result Historically removes 0.28% or 145 loans and in current sample has no effect

The two exclusions I list are not common, mostly originating between 2007 and 2009 (though there have been one each in the past two years). So the basic take away from this statistic, is that it isn't a good indicator of default risk. I included it because I assumed that perhaps mortgage might have a higher default rate in the past 2-3 years because of the credit crisis, but this shows that there is no such correlation.

Other criteria to consider

These are other attributes that can be found on Lending Club's historical data export which I haven't yet analyzed, but may be useful to include.

  • Income Brackets
  • Length of credit history
  • Years of credit history vs length of employment

Analysis of remaining results

After applying the filters above, I also read through the descriptions and any question responses to weed out anything that sounds odd. Usually I look for things like:

  • Divorces
  • Mentions of medical problems in the description or question responses
  • Cases where the person wants to consolidate their debt at a higher rate then they're currently getting
  • Self reported monthly living expenses taking up most of their monthly income, ie leaving little wiggle room to pay debt

Last thoughts

After all this analysis has been applied, you only have to review 10-15% of the loans in funding. This can still leave a high number of loans to consider (around 100 in this case) so I also exclude loans with less than an 11% interest rate.

In the near future I'll be adding another section to this website that will include the notes that I invest in. If you are new to Lending Club, then that may be a good place to start choosing which loans you should invest in.

Lastly, if there are any questions about accuracy or points of confusion in this post, please let me know in the comments below.

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