NOTE: Please refer to this articlefor details about calculation of the expected return at the note level.
Introduction
It is natural to want to measure the amount of money one makes from a financial investment such as Peer Lending. However, calculating returns in Peer Lending is not trivial. It presents unique challenges that must be addressed in order to arrive at a meaningful return that is comparablewith other investment opportunities. The present article explains our method to calculate such returns and how we obtain the performance graphs shown on our website.
We’ll illustrate our calculations with four fictitious loans, detailed in this Google Spreadsheet:
| Loan | Characteristics | Status | Net Payments | Total Net Paid |
|---|---|---|---|---|
| L1 | $10,000 amount, 36 months term, 13% interest rate | Fully paid | 36 times $333.57 | $12,008.52 |
| L2 | $7,500 amount, 36 months term, 13% interest rate | Repaid early | 19 times \$333.57, then full early repayment of $5,209.59 at the 20th month | $11,547.43 |
| L3 | $10,000 amount, 36 months term, 13% interest rate | Current | 7 times $333.57 so far, with 29 payments remaining | ??? |
| L4 | $6,000 amount, 36 months term, 17% interest rate | Defaulted | 9 times $333.57, then stopped paying and defaulted | $1905.99 |
You will also find the calculation formulas in the aforementioned spreadsheet.
Returns Calculations
Conceptually, financial returns are easy to grasp; they showhow much money was gained (or lost) compared tothe initial investment. If \(P_1\) is the sum of payments for loan L1 of amount \(A_1\), then \(R_1\), or the return on investment, is:
\[ R_1 = \frac { P_1 – A_1 } { A_1 } = \frac { $12,008.52 – $10,000 } { $10,000 } = 20.09\% \]
A return of 20.09% on a loan with a yearly interest rate of 13% may look too good to be true. In a way, that’s because it is…
The beauty of the Return on Investment lies in its simplicity, but its pitfall is that it fails to take into account how much time was needed to earn the return. This is especially important in Peer Lending, where monthly payments are expected over a multi-year period.
The loan L2 is also fully paying, but because it repaid early it accumulated less total interest. Therefore its ROI is lower:
\[ R_2 = \frac { $11,547.43 – $10,000 } { $10,000 } = 15.47\% \]
However, this makes little sense; since L2 paid less in total but gave back the money sooner, the returns between L1 and L2 should be roughly comparable.
Time Value of Money
Matters become more complicated when the time value of money is taken into account. A dollar today is worth more than a dollar tomorrow, which means cash received in the futuremust be discounted. A future value FV t years in the future is worth a present value PV, such that
\[ PV = \frac{FV_{t}}{(1 + r)^t} \]
where r is the discounting rate.
Several methods have been devised to calculate time-sensitive financial returns in an attempt to balance ease of calculation with accuracy. The method viewed as the most accurate, and the one we use at LendingRobot, is called Internal Rate of Return (IRR). Calculating the IRR consists of finding the discounting value r so that the sum of n discounted, future paymentsp equals the present value A of the initial investment:
\[ A = \sum{\frac{p_t}{(1+r)^t}} \]
The monthly IRR for loan L1 is r such that:
\[ $10,000 = \frac{$333.57_1}{(1+r)^{1}} + \frac{$333.57_2}{(1+r)^{2}} + \frac{$333.57_3}{(1+r)^{3}} + … + \frac{$333.57_{36}}{(1+r)^{36}} \]
By iterations (there’s no direct way to solve the equation above), we get r = 0.01025.
To obtain the annualized value R from the monthly IRR r, we calculate:
\[ R = (1+r)^{12} – 1 = (1.01025)^{12} – 1 = 13.02\%\]
Predicting Future Returns
After a Peer Lending loan is issuedit is supposed to generate constant monthly payments until it reaches term. A historical return analysis could look at only mature loans in order to estimate a return, but because Peer Lending is relatively new and rapidly growing, a huge proportion of the loans issued have not yet reached their term. Besides, limiting our evaluation to only these mature loans would incur at least a three-year delay in showing performance since the shortest loan durations are 36 months.
We can predict future payments by extrapolating from both historical default rates and survival curves. This enables the construction of a vector of payments combining both past cash flow events p and future cash flow events q, where the future cash flows are discounted to reflect the cumulative probabilities of default. For instance, for loan L3:
\[ P_3 = [p_1, p_2, …, p_7, q_8, … ,q_{35}, q_{36}] = [$333.57, $333.57, …, $333.57, $332.30, …, $317.05, $316.99] \]
A somewhat convoluted formula described in a previous paper allows a loan’s status and number of payments to be taken into account in order to improve that prediction’s accuracy.
This allows us to calculate the ‘expected return’ of loans that have yet to reach maturity.
Averaging Returns
A Peer Lending portfolio is usually comprised of hundreds or thousands of different notes. The easiest way to aggregate returns is to calculate their arithmetic mean.
When evaluating a given portfolio, we can weight each loan’s return by the amount invested in them before averaging. When evaluating overall market performance, we do not weight the returnsby loan amounts, as an individual investor is likely to invest similar amountsof money in every loan.
It is worth noting that aggregated returnsare slightly different depending on if we average the returns of individual loans oraggregate the cash-flows and then calculate the returns:
| Loan | ROI | Expected Return |
|---|---|---|
| L1 | 20.09% | 13.02% |
| L2 | 15.47% | 12.83% |
| L3 | 16.64% | 10.91% |
| L4 | -68.23% | -91.22% |
| Weighted Average Returns of Loans | 2.21% | -6.32% |
| Aggregated Cash-flows Return | 2.21% | 1.59% |
Therefore the calculations mentioned here shall be understood as answering the question ‘How much money do I make on a loan, on average?’ rather than ‘How much money do I make on an entire portfolio?’
Evaluating Returns over time
Determining an investment’s performance over time raises the concern of defining what is meant by ‘monthly return’. For any given month the easiest definition would be to calculate the lifetime return for all loans issued during that month. Examining monthy returns this way does not, however, provide an accurate picture of a portfolio’s performance over time. For instance, a loan issued in July 2007 may have defaulted in May 2009 during the economic recession. Although the loan ended in default, it does not necessarily mean that the investment decision was bad at inception. To fully capture when positive (full payment) or negative (default) events occur, we need instead to average the returns of all the loans currently paying in any given month.
Simulating the Impact of Diversification
A portfolio’s volatility is expected to decrease as the number of securities it contains increases, provided that the performance of each security is uncorrelated.
A Monte Carlo simulation allows us to measure the impact of diversification in Peer Lending without having to make any specific assumptions. In essence, a Monte-Carlo simulation is repeating a random experiment enough times to obtain a reliable average measure. In the present case, it consists of picking random samples of portfolios manytimes, then measuring the distribution of returns. Although tedious and computationally intensive, the process is commonly regarded as reliable. To estimate the range of expected performances, we simulate the returns of a portfolio of different sizes, then keep the 95% confidence interval.
LendingRobot Selection
LendingRobot’s loan selection algorithm ranks loans shortly after their release. To evaluate the performance of the LendingRobot model, we average the expected returns of the top quartile of ranked loans at the time of issuance. Considering LendingRobot is expected to represent significantly less than a quarter of any given platform’s investments, we view the choice of the top quartile as conservative (in other words, a more restrictive choose, such as the top 5% could show significantly higher returns).
Caveats
Although the methods described herein seem based on sound reasoning to us, no simulation or estimation is perfect. It is worth being aware of the following limitations:
- These are only back-tested results. One shall be cautious that such results are often too optimistic, as they come from a model that has been trained on similar data.
- Predictions for the probabilities of default over the life of a loan are only valid as long as the underlying data remains consistent. Said otherwise, extrapolation of past data stops being valid if there are significant changes to anything that may impact default rates (e.g. drastic changes to underwriting policies).
- Loan performances are probably not entirely uncorrelated. For instance, a nation-wide economic crisis may effect the repayments of many different loans.
- Available data is not perfect. For instance, it may be slightly outdated or missing accurate payment history information, requiring some conservative assumptionsto calculate returns. Similarly, some loan data may be inconsistent and needs arbitrary fixes or must be excluded altogether.
- Averaging returns instead of aggregating cash-flows produces an exaggerated impact for defaulting loans, as shown in the four loans example above. As a consequence, newer loans appear as producing vastly improved performance, which may not necessarily be true.
FAQs
What are average return in peer-to-peer lending? ›
Compared with the stock market, P2P lending offers investors the opportunity to generate higher returns through repayments with interest. While the stock market is often said to average an 8% annual return, P2P loans can offer double-digit returns of 10, 11, and even 12%.
How do you profit from peer-to-peer lending? ›Open an account with a P2P lender and pay some money in by debit card or direct transfer. Set the interest rate you'd like to receive or agree one of the rates that's on offer. Lend an amount of money for a fixed period of time – for example, three or five years.
How do you evaluate a loan performance? ›- Pull Through Rate.
- Decision to Close Time Cycle.
- Abandoned Loan Rate.
- Average Origination Value.
- Application Approval Rate. How Ready is Your Loan Application Process.
- Net Charge-Off Rate.
- Customer Acquisition Cost.
- Average Number of Conditions Per Loan.
Investing in peer-to-peer (P2P) lending is a great way to boost yields and diversify your portfolio significantly. P2P lending is an alternative asset that offers attractive absolute and risk-adjusted returns, even in today's low-interest-rate environment.
How much can you invest in peer to peer lending? ›Borrowers can get peer-funded loans anywhere from $4,000 to $25,000 with fixed rates as low as 5.99%. You'll have to pay an origination fee anywhere from 1% to 5% when you get the loan, but after that, there are no hidden fees and no prepayment penalties.
Is money lending profitable? ›They continue to charge high rates of interest, which in turn leads to super normal profits. Money lending, hence has always been and will be one of the most lucrative business.
Is peer-to-peer lending passive income? ›3. Peer-to-peer lending. Another way I decided to diversify my investment portfolio and make passive income was through peer-to-peer lending. This is when you loan money to borrowers who might not qualify for traditional loans.
Can I lend money and earn interest? ›Can I lend money to a friend and charge interest? Yes, you can, but the tax ramifications can be tricky and complicated. You would have made interest on the money if you had kept it in an interest-bearing account, and that's one good reason to charge interest.
How do you analyze financial statements for giving loan? ›- Access Cash Balance on the Applicant's Bank Statement. ...
- Analyse Deposits on the Bank Statement of the Loan Applicant. ...
- Examine Withdrawals and Liabilities on the Bank Statement. ...
- Scrutinise Cash Overdrafts on the Bank Statement.
A mortgage pull through rate is the total number of funded loans divided by total number of applications multiplied by 100. For example, if 100 potential borrowers complete applications and 70 of those loans fund, the result is a 70% pull through rate.
Why do lenders need financial statements? ›
Lenders rely on financial statements to obtain critical information about the financial health and risks of businesses. The average lenders don't have ongoing inside access to the day-to-day operations of a company.
What is the most common risk of the lender? ›Credit risk is the biggest risk for banks. It occurs when borrowers or counterparties fail to meet contractual obligations.
Which of the following is a risk when investing in peer-to-peer P2P products? ›The risk of loan default and late debt repayments
You know that P2P lending is a debt-based investment where investors lend money to individuals or businesses. You gain returns from the interest rates. That means the most significant risk in peer-to-peer lending is Borrower risk.
- Clean up your credit. Credit scores are major considerations on personal loan applications. ...
- Rebalance your debts and income. ...
- Don't ask for too much cash. ...
- Consider a co-signer. ...
- Find the right lender.
First off, yes, it's definitely taxable. There's no need to panic though as the taxation terms on P2P loans are actually pretty reasonable. The interest you receive through loans is taxable just like any other form of income.
How do investors get paid back? ›There are a few primary ways you'd repay an investor: Ownership buy-outs: You purchase the shares back from your investor depending on the equity they own and the business valuation. A repayment schedule: This is perfectly suited to business loans or a temporary investment agreement with an assumption of repayment.
Which states do not allow peer to peer lending? ›States where there is No Lending Allowed: Arizona, Ohio, New Mexico, North Carolina, North Dakota, Pennsylvania, Texas.
Does peer-to-peer lending affect credit score? ›P2P loans generally offer competitive interest rates and fixed monthly payments. Applying will not affect your credit score, and the credit requirements may be less strict than at traditional lending institutions.
Where can I invest in passive income? ›- Rental property real estate.
- REITs.
- Stock market.
- Bonds.
- Certificates of Deposit (CDs)
- Mutual funds.
- Peer to peer lending.
- Turnkey real estate.
Mortgage lenders can make money in a variety of ways, including origination fees, yield spread premiums, discount points, closing costs, mortgage-backed securities (MBS), and loan servicing. Closing costs fees that lenders may make money from include application, processing, underwriting, loan lock, and other fees.
What is hard lending? ›
A hard money loan is a short-term, non-conforming loan for commercial or investment properties, that doesn't come from traditional lenders, but rather people or private companies that accept property or an asset as collateral.
How does hard money interest work? ›To calculate the total interest paid on a hard money loan, you essentially just multiply the monthly repayment amount, by the number of months that you hold the property for. So if your repayment is $1500, and you hold the property for 12 months, the total interest paid would be $18,000.
How can I make $1000 a month passive income? ›- Invest in Dividend Growth Stocks.
- Invest in (crowdfunded) real estate.
- Earn credit card sign-up bonuses.
- Earn new bank account promotions.
- Save with a High Yield Savings Account.
- Save with Certificates of Deposit (Brokered & Regular)
- Virtual assistant.
- Internet scoping.
- Blogging.
- Freelance your skills.
- Photography.
- Teach English.
- Amazon.
- Rent out your stuff.
- Real Estate. Investing in real estate is a strategy to earn passive income. ...
- Short-Term Rentals. ...
- Peer-to-Peer Lending. ...
- Stock-Picking. ...
- Dividend Payments. ...
- Affiliate Marketing and Other Online Earning Options. ...
- Freelancing and Independent Contract Work. ...
- Re-Sell Things on Online Marketplaces.
Well, the easy answer to those questions is yes - it is legal to lend money and charge interest, and in most cases, you should charge interest when lending money to someone you know. Failing to do so can result in tax penalties with the Internal Revenue Service (IRS), which can become costly.
What is a fair interest rate for a friend? ›The proposal should include: The amount to be borrowed (principal). Interest rate (You should offer, even if they're likely to decline. For a long-term repayment, 2% to 4% is reasonable.)
What are the advantages and disadvantages of peer to peer lending? ›- Interest Rates. ...
- Diversification. ...
- Variety. ...
- Ease of Use. ...
- Secondary Market. ...
- Innovative Finance ISA. ...
- New FCA Regulation. ...
- Your capital is at risk.
Three of the most important techniques include horizontal analysis, vertical analysis, and ratio analysis.
What financial statements do lenders look at? ›Lenders will evaluate balance sheets and income statements using a ratio analysis approach. The ratios creditors use typically include debt-to-equity, debt-to-assets, quick ratio, and current ratio but may include others as well, depending on the banking institution.
What is revenue pull-through? ›
The pull-through rate measures the ability of a salesperson to close a sale transaction. The sales manager should use the pull-through rate on an ongoing basis to measure the closing capabilities of his or her sales staff.
What is a rate lock derivative? ›Rate locks: a hedging agreement that is terminated at a specific date in the future, with a cash settlement payment that reflects changes in municipal interest rates. This settlement payment is designed to offset changes in the cost of borrowing for the hedged bond transaction.
What are pull-through sales? ›So what is a pull-through sales strategy? It is a technique used to attract interest to your brand. Rather than pushing your offer to the customer, a pull-through sales approach entails the use of pull schemes or the communication of information to bring people to you.
Which of the 3 financial statements is most important? ›- Income Statement. The most important financial statement for the majority of users is likely to be the income statement, since it reveals the ability of a business to generate a profit. ...
- Balance Sheet. ...
- Statement of Cash Flows.
They are: (1) balance sheets; (2) income statements; (3) cash flow statements; and (4) statements of shareholders' equity. Balance sheets show what a company owns and what it owes at a fixed point in time. Income statements show how much money a company made and spent over a period of time.
What investors look for in financial statements? ›Investors will want to see information that indicates the current financial status of the business. Usually they will expect to see current reports such as a profit and loss statement, a balance sheet and a cash flow statement as well as projections for the next two or three years.
What are the 3 types of credit risk? ›Credit Spread Risk: Credit spread risk is typically caused by the changeability between interest rates and the risk-free return rate. Default Risk: When borrowers are unable to make contractual payments, default risk can occur. Downgrade Risk: Risk ratings of issuers can be downgraded, thus resulting in downgrade risk.
What are the 4 types of risk? ›- strategic risk - eg a competitor coming on to the market.
- compliance and regulatory risk - eg introduction of new rules or legislation.
- financial risk - eg interest rate rise on your business loan or a non-paying customer.
- operational risk - eg the breakdown or theft of key equipment.
There are several steps a lender can take to mitigate credit risk including using risk-based pricing, requiring loan covenants, and diversifying the portfolio, among others.
How can you lose money with P2P? ›The Risk in Using P2P Payment Apps
What many consumers do not realize is that P2P services have limited, if any, fraud protection, and they do not offer the same consumer protections as a credit card, debit card, or even writing a check. Once the money is sent, it's gone.
Is money lending profitable? ›
They continue to charge high rates of interest, which in turn leads to super normal profits. Money lending, hence has always been and will be one of the most lucrative business.
What risks does the lender face when participating in P2P lending? ›- Yourself (psychological risk).
- Not enough diversification (concentration risk).
- Losing money due to bad debts (credit risk).
- Losing money due to a P2P lending site going bust (platform risk).
- Losing money due to fraud or negligence.
- Selling into a loss (crystallising losses).
The easiest loans to get approved for would probably be payday loans, car title loans, pawnshop loans, and personal installment loans. These are all short-term cash solutions for bad credit borrowers in need. Many of these options are designed to help borrowers who need fast cash in times of need.
What does a lender look at before granting credit? ›Your income and employment history are good indicators of your ability to repay outstanding debt. Income amount, stability, and type of income may all be considered. The ratio of your current and any new debt as compared to your before-tax income, known as debt-to-income ratio (DTI), may be evaluated.
What factors would the bank consider before granting loan? ›- Your credit. ...
- Your income and employment history. ...
- Your debt-to-income ratio. ...
- Value of your collateral. ...
- Size of down payment. ...
- Liquid assets. ...
- Loan term.
Traditional performance measures are similar to those applied in other industries, with return on assets (RoA), return on equity (RoE) or cost-to-income ratio being the most widely used. In addition, given the importance of the intermediation function for banks, net interest margin is typically monitored.
How would you measure the performance of the bank teller? ›Much of what tellers do can be quantitatively measured: transactions, cash, accuracy, transaction volume, sales referrals, fees collected, etc. These metrics should be the foundation of performance measurement. However, simply counting each teller's metrics is not necessarily fair.
How do you calculate profitability on a loan? ›That is, C/L = E/A, where C is the assigned capital, L the loan size, E the total equity, and A the total assets of the bank.
How is financial strength of a bank calculated? ›You can view the quarterly and annual changes of a bank's total deposits in their reports or on the FDIC website. Look at the bank's available capital, or cash. Strong capital indicates there are more assets to cover any potential losses.
How do you calculate bank profitability? ›What Is a Bank Efficiency Ratio? An efficiency ratio is a calculation that illustrates a bank's profitability. To calculate the efficiency ratio, divide a bank's expenses by net revenues. The value of the net revenue is found by subtracting a bank's loan loss provision from its operating income.
What are three key performance indicator areas for a bank? ›
...
Financial
- Revenue: All incoming cash flow. ...
- Expenses: All costs incurred during bank operations. ...
- Operating Profit: Money earned from core business operations, excluding deductions of interest and taxes.
- Earning Asset Yield (EAY) ...
- Cost of Funds (COF) ...
- Net Interest Margin (NIM) ...
- Average Earning Assets. ...
- Average Interest Bearing Liabilities. ...
- Non-Interest Income/Total Revenue. ...
- Non-Performing Loans. ...
- Coverage of Non-Performing Loans (NPLs % Allowance for Loan Losses)
The most important indicators include interest rates, inflation, housing sales, and overall economic productivity and growth. Each bank investment decision should include an evaluation of the specific bank's fundamentals and financial health.